Legal rules determine an award of damages in the event one party to a contract fails to perform. This research investigates the impact of these damage rules on the promisor's decision to perform and on the promisee's decision to rely on the promised performance.; In the model, the "seller" promises the "buyer" a performance in exchange for a price. The seller's ability to perform depends both upon the state of nature and upon his act selected prior to learning the state of nature. The ability of the law to induce socially optimal acts is investigated under assumptions of the risk preferences of the parties, in the presence of reliance by the buyer (i.e., when he makes an expenditure that increases the value of performance, but not of breach), in the presence of seller reputation, and under various combinations of these three assumptions.; Expectation damages, the prevailing rule of law, induces socially optimal acts only if the parties are risk neutral and the buyer has no reliance decision. A simple modification of the expectation-damage rule induces both optimal performance and optimal reliance in a risk-neutral, anonymous world. In a risk-neutral world with reputation and reliance, a rule of no damages induces socially optimal behavior. In a risk-averse world, the optimal rule depends on the risk preferences of the two parties.; Three other propositions are of particular interest. First, no rule based on actual damages is always superior to expectation damages in a risk-neutral, anonymous world with reliance. Measures based on actual damages are attractive to courts because actual damages can more easily be proved than damages based on hypothetical acts. Second, the author obtains comparative-static results in an anonymous world with risk aversion. As the degree of buyer risk-aversion increases, the optimal measure of damages increases. The optimal measure declines as the seller grows more risk averse. Third, the author derives conditions under which anonymous worlds are pareto inferior, pareto superior, or pareto incomparable to worlds with reputation.
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