Lost Volume Theory: A Simple Recap

If there is one principle that’s key to understanding contract damages is that the legal system is terrified of someone getting more compensation than what they deserve. One mustn’t profit from a breach of K. Put the non-breaching party in the position they would’ve occupied but for the breach, but not a better one. What follows from this principle is less intuitive. Contrary to what you might think, the legal system is fine with letting people who breach contracts get away with paying less–so long as the people whose contracts were breached won’t get more. (disagree? think about the combined effect of certainty, mitigation, and foreseeability, and then think about the anti-punitive-damages stance permeating liquidated damages analysis). So if a general contractor breaches a rehab K they had with a flipper, the losses may be estimated at $40,000. But the legal system would be 10 times more worried about giving the flipper $40,100 than it would about the possibility of letting the GC pay only $30,000. (why? probably because of the old myth that expectation damages are not ‘real’ in the way reliance damages are–the sentiment channeled by Fuller & Purdue).

OK, so giving the non-breaching party more than they lost is a K faux-pax; what does that have to do with lost volume sellers? What are lost-volume sellers?

If you feel confused about the lost-volume doctrine, the problem is not with you. It’s the doctrine itself that’s confused.

Consider Adam. He recently discovered he can supplement his income by flipping cars–he finds people trying to get rid of their cars, buys them, and then sells them at a small profit. Adam was just able to put his hands on a 2020 Toyota 4Runner, for which he paid only $40,000. It’s in excellent condition and with only 20,000 miles on it, so Adam figures he can sell it for somewhere between $44,617-$47,701 (according to the KBB), with $46,169 as the middle point. Not bad!

Rachel contacts Adam, telling him she urgently needs a car, and she is willing to pay his requested $47,169 (a $1000 more than the midpoint). They sign a K, but the next day she calls him and says she found a cheaper car, and she is no longer interested in the car.

If Adam were to bring a lawsuit, what would be the measure of damages?

The UCC has this easy formula: K-Mkt. That is, the K price (here we said it was $47,169) minus the market price (here KBB tells us it’s $46,169). So under the UCC, Adam should get $47,169-46,169=$1,000.

The common law has a different approach. It focuses on lost profits. If we were to apply the formula of (Expected profits under the K) – (Actual profits after the breach), we would seem to get a very different number. The breach left Adam with no profits–the sale didn’t go through. He expected, however, to turn a nice profit of $47,169-$40,000=$7,169. Buying a car for $40k and selling it for $47 is a pretty good deal.

But remember the common law’s fear of over-compensation? We notice that if we were to give Adam $7,169 in compensation, he would be in a better position than he was prior to the breach because not only he has the profits of the flip, he also has the car. If he now finds a new Rachel, he will get another $7,169, so double his expected damages. And the common law won’t allow anyone to profit from a breach. So we will deduct from his lost profits the market value of the resale value of the car he gets to keep, and so he gets only $1,000. Same as K-Mkt.

To recap: If we use the UCC formula, Adam gets $1,000. If we use the lost profits formula, Adam is supposed to get $7,169, but we only give him $1,000. So the same under both.

This is where the Lost Volume Doctrine kicks in. It tells us that if Adam has a large stock, we can (a) use lost profits rather than K-Mkt and (b) ignore the fact that he gets to keep the car. If we were to apply it here, Adam could recover the full $7,169. Not bad.

But why?

Well, here’s the Official Story. Suppose a widget broker has access to an ‘infinite’ supply of widgets from a factory (this can’t be literally true, but bear with me). To save the trees, we’ll recycle our numbers and suppose that clients order widgets from the broker at a quoted price of $46,169. For each one bought, the broker puts in an order and pays $40,000 to the factory. Now suppose that a client breaches the K after the broker puts in the order. Both UCC and Lost Profits would mean that broker can’t get any damages (see Box below) and to some people that feels unfair. The broker had an expectation of a certain ‘volume’ of sales; when the client breached the K, they frustrated this expectation imperssimbly. Giving the broker 0 compensation appears unfair, and so the idea is that some compensation is due. How much? Exactly how much profit the broker gets for every marginal increase in the volume–i.e., $46,169-$40,000=$6,169. We are compensating, in other words, for the loss of sales volume.

UCC (K-Mkt)
K= contract price = $46,169
Mkt = Market Price = $46,169
K-Mkt = $46,169-$46,169 = $0

Lost Profits
K price = $46,169
Resale value of the widget = $46,169
Damages = $46,169 – $46,169 = $0.

Illustration: In Locks v. Wade we have a broker that instead of widgets rents out nifty jukeboxes (what’s the proper, non-anachronistic adjective here? razz my berries? Made in the shade? Daddy-O?) that it orders from its supplier. Each rental nets the broker $840. A breach, in one sense, doesn’t leave the broker worse-off–it can still rent out the same jukebox to another hip diner. But the court adopts the lost volume doctrine and allows the broker to recover the $840.


Now let’s move on to the fun part– critique. Does any of that make sense? I don’t think so. What is volume and how one loses it? And if such a thing exists, why isn’t a volume of one sale enough to get one the royal treatment? Would three lost sales be enough? I’m not nitpicking here: I recognize that there are many good legal rules where a bright line is hard to draw. My point is rather that there is no principled reason to draw the line anywhere.

Courts try to limit the doctrine only to cases where sellers have an ‘unlimited’ supply of goods. The meme I made below summarizes what I think about the merits of the argument, but I also find this to be completely arbitrary. Why isn’t a large stock enough? What makes the volume important?

Now there is this odd issue of horizontal and vertical equity if you will. This rule is anti-consumer in effect. Under standard K rules, if a consumer buys a car from someone, they have a way out in case they later regret it. The standard rule offers consumers an almost no-penalty way out. You may not like this rule, but surely you wouldn’t support a carve out that abolishes the o-cost termination only when buying from large sellers? Nor does it appear principled to apply different compensation schemes to large and small sellers–if anything, it appears absurd to offer compensation only to large sellers who are in a better position to shoulder the risk.

The most persuasive reason, I think, was put forward by Vic Goldberg. What do we think most parties would want? Would they want a no penalty termination clause? Would they prefer the lost volume’s approach of compensating sellers for their lost volume? If you look outside stare at your monitor, the answer is fairly self-evident. Most online consumer transactions today offer free returns, sometimes even with no-cost shipping. I decide to cancel my order of the Kindle Paperwhite because a voice in my dream told me that I’d be happier with an iPad (I have very strange dreams, don’t ask). In standard analysis, this would be a breach and not just a breach, but a ‘deliberate’ breach. Amazon clearly loses sale volume. But Amazon doesn’t care–I have a 0 cost option to terminate at will for whatever arbitrary reason. Amazon can anticipate that every quarter it loses a certain volume of sales due to hallucinating consumers, and it just prices the ‘loss’ in its product, and consumers seem keen to pay a premium for having the ability to back out when they want.

So, the conclusion is yes. The lost volume seller doctrine doesn’t make sense, courts took a wrong turn at some point, and it’s not too late to undo the mistake.

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