LAW AND ECONOMICS
HANDOUT #2

EFFICIENT PRECAUTION AND RELIANCE:

USING THE LANGUAGE OF EXTERNALITIES

    The promisor derives some benefits from precaution if additional precaution reduces his liability for harm to the promisee. Such additional precaution also provides an external benefit to the promisee in the form of reduced harm from a potential breach. Efficient precaution occurs when additional unit of precaution reduces the dollar value of the promisor's liability by an amount that is equal to the dollar value of the reduced harm to the promisee from potential breach. Such an action, internalizes the external benefits provided by precaution.

    The promisee externalizes the costs of reliance when increased reliance causes the promisor's expected damage payments to increase. Reliance costs are internalized when the promisee is not compensated for any increase in reliance. Such reliance is efficient because the promisee bears the full cost of added reliance. Thus the promisee is normally compensated for foreseeable reliance damages but not for unforeseeable ones. This distinction limits the amount of reliance damages payable to the promisee and hence induces some caution on the promisee's part as to how much reliance to incur.

    A paradox arises because internalizing the full benefits of precaution provides efficient incentives for the promisor but, by allowing the promisee to externalize all added reliance costs, provides incentives for inefficient (over) reliance. Efficient reliance requires that the promisee bear the full cost of additional reliance (making damages invariant to the amount of reliance) which causes the promisor to reduce precaution below the efficient level.

    The resolution of the paradox requires that damages be fixed at the level of efficient reliance; this also provides the efficient level of precaution. (Again, the book's solution requires courts to determine the level of damages in a case in which it is a third party to the bargain. Such a solution should be contrasted with the use of specific performance and liquidated damage clauses which rely on the parties themselves to devote resources to dispute resolution. The latter solutions induce the low-cost providers of information to solve their own conflicts.)