Optimal Pricing with Product Quality Differences and Contractual Penalties

There is quite a debate between legal scholars from Civil and Common Law systems on whether contractual penalties should be enforced by courts. In this contribution we look at this question from a different angle by modelling a monopolist trying to find optimal prices when contracts without penalty as well as contracts with penalties are offered simultaneously to a class of buyers who face different levels of loss risks. We find that neither changes in legal indemnities nor in privately stipulated fines alter those prices. Also, seller s profit and consumer surplus are not influenced by such changes. Therefore we conclude that full enforcement of penalty clauses as agreed upon is the best recommendation in order to reap benefits like optimal inter-party risk-allocation.