Student Blogger - Are Our Reactions to "Willful Breach" Rational?

Imagine you are at the airport gate waiting for a flight home on Christmas Eve, and an announcement is made: your flight has been overbooked. Even though the airline offers significant compensation, and even though you know this is a standard practice from which you benefit in the form of lower ticket prices, you are (probably) quite angry. Or imagine that you have ordered a custom bicycle from a high-end shop. Later you go to pick it up only to find out that the shop has sold it to someone else who made a better offer. Even though the shop refunds your money and offers you a valuable coupon, you remain angry and might resolve not to do business with the shop anymore.

Both examples are cases of "efficient breach," which law and economics scholars have powerfully argued should not be punished above and beyond standard compensatory remedies for contract breach. According to the standard account, these kinds of actions are in fact social-welfare maximizing (so long as the "victim" is compensated), so that even if we are (possibly irrationally) aggravated by them individually, we should permit and even celebrate them as a society, and at a minimum refrain from punishing them. At least doctrinally, this describes the law (at least in the US) - it does not entitle you to any extra compensation for these "willful" breaches of contract.

But this is not always true in practice - courts in the US often award punitive damages or similar remedies for breaches of contract characterized as willful. In other countries, particularly those with civil law systems, the law may explicitly provide for different penalties for willful and non-willful breach. Why doesn't practice match up with theory and doctrine? More deeply, why are even economists and others who pride themselves on rational thinking still aggravated by these kinds of behavior when they experience them?

Professor Omri Ben-Shahar has attempted to answer these questions in his paper (with Professor Oren Bar-Gill of NYU) "An Information Theory of Willful Breach," which he presented at this week's Works in Progress (WiP) talk at the Law School.

To greatly simply Prof. Ben-Shahar's analysis, he argues that those behaviors that we characterize as willful breach are penalized not because of something "bad" about them per se (the intuition that the economic analysis of efficient breach explicitly rejects), but because they signal other underlying behaviors that are both worth punishing and difficult or impossible to attack directly.

To illustrate this, Prof. Ben-Shahar returned to the airline overbooking example mentioned above. He suggested that we are angry about, and might punish, the overbooking practice not because it is "unfair" or otherwise blameworthy, but because it is indicative of an underlying, systematic failure to make good investments in and choices about consumer interests. In other words, his explanation goes, overbooking reflects (or at least might reflect) a general airline practice of "screwing" consumers that is both hard to catch and largely happens outside of the contractual context, where it can't be punished even if it can be detected.

Prof. Ben-Shahar noted some similarities between this approach and the "character theory of punishment" in the criminal law context, in which more severe punishment of behavior for which the defendant is convicted is justified on the grounds that it is evidence of deeper problems - though he noted that the problems addressed by willful breach penalties are bad ex-ante investments and choices, rather than character flaws of some kind.

Later in the talk Prof. Ben-Shahar added an important piece to this analysis - that it depends on some form of market failure. If prices include accurate judgments about the level of ex-ante investments (or, to put it more directly, if customers have an accurate sense in advance of which companies are going to screw them), then no ex-post punitive damages for willful breach are needed.

While this account seems like a theoretically sound explanation of observed behavior, commenters at the WiP offered some criticism. One commenter urged Prof. Ben-Shahar to be careful to distinguish between implying that willful breach itself is bad (that is, social-welfare reducing) rather than that it signals some underlying bad conduct. The commenter further noted that Prof. Ben-Shahar, a law-and-economics scholar by vocation, is in fact making arguments very similar to those offered in more general philosophical critiques of the rationality of utilitarianism. While I don't have the background to evaluate this particular criticism, it does fit in with my general sense that there are deeper issues implicated by Prof. Ben Shahar's arguments.

More practically, it would be useful to identify what "bad" (or, as Prof. Ben-Shahar later characterized them, "rent-seeking") behaviors may be associated with willful breach. Even after identifying these possibilities, the empirical question of whether they are in fact associated remains open (though it would surely be better addressed in subsequent work).

A broader critique, and in my opinion a more dangerous one for Prof. Ben-Shahar's arguments, is simply the possibility that we as individuals and a society are making a mistake when we attempt to assign additional punishment to willful breach. The alternative story goes something like this: it is part of human nature to attempt to punish some kinds of behavior, even if it appears irrational to do so. Behavioral economists have identified one example of this in studying the "ultimatum game," in which participants were found to consistently reject deals they perceived as unfair even if they "left money on the table" by doing so. This can be explained, possibly, as a culturally or evolutionarily determined behavior that seeks to enforce behavioral norms - if one gets a reputation for rejecting bad deals, the account goes, people will offer you better deals in the long run. The instinct then misfires by creating the behavior observed in the game, even though there is no repeat play.

A similar facet of human nature may explain our individual anger at efficient breach - even though we might realize its general benefits, this deep instinct still drives our emotional response. But the reputational benefits of penalizing behavior perceived as "bad" don't exist when the practice is generalized to a legal rule - as others have shown, when efficient breach is penalized generally, the result is simply a reduction in social welfare. The instinct to punish has value for individuals, but not as a principle on which to base rules for the group. Prof. Ben-Shahar suggests that there is more going on here in that other, underlying behaviors are being detected and punished, but isn't it just as likely that we are applying intuitions that are appropriate to individual conduct to group rules, where they don't make sense anymore? Other human instincts, such as revenge, clearly don't work as rules for a society, so why should this one - or why should we conclude that it is anything other than a reflection of individual, emotional responses?

Similarly, human intuition rather than rational analysis seems to drive the definition of willful breach itself. Some commenters and Prof. Ben-Shahar himself pointed out that in terms of our emotional reactions and often in law, we treat the breacher who profits from breach (like the bike shop owner who sells to a higher bidder) differently from the one who makes savings due to breach (like a shop owner who breaches because materials have become much more expensive). Economics teaches us that the two are not really distinguishable. Why should it be the case that in one scenario, breach indicates underlying behavior worth punishing, while in the other it does not? Isn't it more likely that this variation in treatment comes from some human instinct gone haywire? One commenter called it a "misfiring intuition" and analogized it to the action/inaction distinction, which seems to be deeply rooted in our minds, but is difficult or impossible to explain rationally.

Prof. Ben-Shahar's best response to these criticisms is that he is trying to give as much credit as he can to observed behavior and identify its root cause, rather than simply dismiss it. While the instinct to explain rather than reject observed behavior is undoubtedly a good one, at some point explanations can either become so tenuous or so complicated that Occam's Razor pushes us towards the possibility that observed behavior is simply systematically irrational, though one must always be careful to avoid telling a "just so" story that lacks real explanatory or predictive power. I'm not sure that our treatment of willful breach is best explained this way, but it is a powerful criticism that Prof. Ben-Shahar will have to confront as the paper develops. I, for one, look forward to seeing that debate play out.

   

Comments

[Tim Cullen]

Let me add two other observations about how the legal acceptance of efficient breach might actually reduce social welfare. (On a personal note, this doctrine has bugged me since I learned it in my 1L contracts class--taught by a UChicago alum, no less).

First is the degradation to the value of all promises when a contract is efficiently breached. I'm sure this has been studied empirically, but I would imagine that aggregate damage that occurs because of these 'efficiently' broken is not insubstantial. At what cost is the increased uncertainty and risk associated associated with contracting in an environment where promises can be broken if the underlying economics change? Is there any work on this approach out there?

Following from that is the internal adjustment all contracting parties must make to accommodate this initially non-intuitive facet of our laws. While corporations can make this adjustment without any real difficulty, individual consumers (read: humans) probably expend significant psychic
energy re-framing their approach to contracts once they've been the opposite party to an 'efficient' breach. I wonder if that non-intuitive re-framing is more socially costly in aggregate than the efficiencies gained in the breach. It's been shown that we as a species are hard-wired to feel wronged by broken promises. That we must re-wire against a biological default (beyond what is required simply to incorporate the increased risk f breach noted above) is most likely an uncaptured cost in most legal economists' analyses.

[Nathan Richardson]

Interesting comment. I particularly like the your argument that the "biological default" actually reflects real underlying costs; I think this is very similar to what Prof. Ben-Shahar is arguing.

But it might boil down to an argument not against efficient breach, but simply that damages for breach aren't sufficient? For a breach to be efficient, it has to make all parties better off after a compensatory side payment is made to the original promisee by the breaching party, and this often includes more than just a straight refund.

In the example in the post, the bike shop gives you your money back plus a coupon. In essence, you're saying that the coupon isn't enough to compensate you for these adjustment and "psychic" costs. (also, explaining these "psychic" costs might be exactly what Prof. Ben-Shahar is getting at) If true, you could theoretically sue and claim reliance damages. Efficient breach says that even if you sue, and win, your measure of damages should be the same regardless of whether you can characterize the breach as willful.

In other words, for breach to be Pareto-optimal, the side payment has to be enough to make you no worse off than you were before. If it's not enough, breach still might be Kaldor-Hicks efficient, but the law doesn't consider that to be enough since you're the promisee.

Of course, for consumers it's rarely if ever going to be worth suing to get adequate compensation. Breachers have an incentive to give you a remedy that falls short of compensating you (but by less than your perceived litigation costs). This is balanced by reputational costs, but probably not to the extent that consumers get full compensation for reliance in most cases.

In other words, your comment might (I think) be rephrased to say that efficient breach is fine in theory, and fine for large deals between sophisticated players, but doesn't work for consumer transactions because of litigation expenses (and other transaction costs).

To the extent that this is what you mean (and I may be mischaracterizing it), I think it has to be right, but it doesn't answer the question of why we have this deep emotional reaction to breach, or why we treat willful breach differently in the law.

[Omri Ben-Shahar]

The idea of efficient breach poses a wonderful dilemma. To every law-and-economics person it makes sense, and to everyone else it doesn't. It makes sense because it is in the interest of contracting parties -- efficient breach is a way to make money without altering the distributive outcome and without harming anyone else. And yet it doesn't make sense because there is a substantial amount of evidence that transactors, even sophisticated ones, reject it. The notion of "sanctity of contract" that is often invoked to justify the resentment to efficient breach is devoid of explanatory power. It does not tell us why a particular type of breach violates the sanctity while other types do not. In search of an "underpinning" for this notion--for an explanation why willful efficient breach is popularly perceived as wrong and punishable--my paper provides an information-based theory, as described in the main post above. It may well be that this theory is not truly needed, if we are ready to dismiss the opposition to efficient breach as simply wrongheaded. Some of this opposition might indeed be misinformed and irrational. but my own view is that we can do better than dismiss the opposition. A more nuanced economic account of efficient contracting demonstrates that the opposition to efficient breach has solid foundations in ... efficiency!

[Kimball Corson]

It is an interesting comment, indeed. However, I am left wondering if the basic rational for not penalizing willful breaches is simply not known or well enough understood and therefore undermined by inadequate laws and ill-considered sentiments. To the ill or uninformed, willful breach may indeed smack of something bad or close to it, but that is hardly a compelling argument, especially if other law is set right as it was regarding the recovery of attorneys´fees for breach in most jurisdictions.

[Tim Cullen]

Thanks for responding to my comments. I actually think that when more sophisticated agents inadequately compensate less sophisticated ones during an efficient breach such that it makes no economic sense to sue is reflective of a more widespread but separate phenomenon, outside the scope of this post.

@Mr. Richardson: in your penultimate paragraph, you nailed all the way up to the word 'because.' I'm not sure it makes sense to learn why exactly humans feel an emotional reaction to breach. What's important is that we learn to quantify it or learn the costs of de-emotionalizing (if that's a word) our response to breach in order to set our legal thresholds efficiently.

@Professor Ben-Shahar: I don't think opposition to breach is irrational (especially for individual actors)--I just think we undervalue the costs of remedying because our emotional response is hard to quantify.

Lastly, is there a link to the paper available?

Thanks for the stimulating conversation.

[Uzair Kayani]

I wonder if the emotional resistance to efficient breach would disappear if every contract explicitly stated that the promissor might breach and pay expectation damages. Alternatively, every contract could have a liquidated damages clause. Put differently, we could have a "warning label" on contracts.

People would then treat contracts the same way that they treat securities: they would be cognizant of the risks involved and not rely too much on performance. The emotional resistance to efficient breach might be a symptom of promisee over-reliance.