Breach Remedies, Reliance, and Renegotiation

Breach penalties can be used to protect specific investments and are therefore a remedy against holdup. Not all breach remedies are, however, equally efficient. Some common types are predicted to protect too well thereby inducing overinvestment. Theoretically overinvestment is driven by two motives: the insurance motive and the separation prevention motive. This paper presents results from an experiment designed to test the effect of different breach remedies on specific investments in a setting where ex post renegotiations are possible. In line with other experimental studies we find that actual investment levels tend to exceed the predicted levels somewhat. Nevertheless the results provide ample support for the theory: investment levels under the different remedies vary in accordance with the theoretical predictions. More specifically, where predicted the insurance motive and the separation prevention motive are indeed at work