Installment Contracts and Material Breach

Default rules in contract law grant a buyer the right to terminate a contract over the recurrent delivery in multiple periods (i.e., an installment contract) and cancel future deliveries if, and only if, past deliveries by the seller are sufficiently defective (putting the seller in “material breach”). Using an incomplete contracts framework with buyer’s relationship-specific investment, I show that, absent other contractual solutions, an installment contract can solve the buyer’s holdup problem and implement the “first-best” (i.e., efficient) outcome. Multiple independent contracts over one delivery each, installment contracts without the right to terminate, or installment contracts with noncontingent rights to terminate cannot solve the buyer’s holdup problem. I also show that the optimal termination right is not too buyer friendly when the buyer has low bargaining power in ex post renegotiations. This result serves as an economic rationale for the restriction of termination rights to cases of material breach of contract.

Ganglmair, Bernhard (2018), Installment Contracts and Material Breach, Supreme Court Economic Review 26 , 1-46