The roles of downpayments, interim payments, and penalty clauses to the breach in contracts

Abstract

This dissertation offers a model which is able to solve the moral hazard problem in an unverifiable- effort contract with two features. First, the buyer can walk away at the end of each period, but must pay a penalty to the seller if he does so. This ability to walk away provides an incentive for the seller to exert effort Second, the buyer and the seller negotiate over the penalty clause in the contracting period. Under Nash bargaining, a contract which is able to achieve the first-best outcome is adopted. There are several advantages of this type of contract. First, the first-best outcome is achieved. Second, both the buyer and the seller reap positive benefits. Third, the penalty payments do more than simply transfer surplus from the buyer to the seller. But which feature drives the efficiency of this type of contract, the penalty payments or the walk-away clause? By examining the comparative effects of penalty clauses and downpayments on contracts with take-it-or-leave-it rule and renegotiation rule, it is found that penalty payments and downpayments can be used interchangeably, and that the walk-away clause is what drives the efficiency result. Although a random variable, in a form of added value to the complete project, is added into the model, the first-best outcome as an equilibrium shows robust to the uncertainty.