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The buyer's behaviour

Given that the buyer is fully compensated under the expectation damages rule, the expected value of the contract to the buyer under expectation damages is:

For any xB, the seller will choose precaution up to the point where private marginal benefit equals private marginal cost. But note that the above expression is independent of the probability p(xs). The buyer has a dominant strategy - to choose xB so that:

which is satisfied at the point xEB = x° > x*. Under expectations damages, the buyer overinvests in reliance.

Equilibrium

Given the behaviour of the buyer, the seller's choice of care will then satisfy:

Since V(xE) > V(x*) and the right-hand side is equal to ws, it must be the case that on the left-hand side we have:

so:

)

Since p'(xS) is negative, and since p"(xS) > 0, this means that xE > x*. The seller invests in the optimal amount of care given the level of reliance, but since the buyer overinvests in reliance, the seller also overinvests in care from an efficiency point of view.

This result is exactly analogous to the rule of strict liability in the bilateral model of accident law. Since expectation damages fully insure the "victim" of the breach (the buyer), the buyer underinvests in care (overinvests in reliance), and the "injurer" (the seller) overinvests in care.

 
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