Compensatory Damages

Compensatory damages are those damages (i.e., a financial judgment) awarded by a court that are intended to reimburse an injured party for the harm caused by the actions of another. These damages are awarded in a wide variety of legal actions (e.g., torts, breach of contract, wrongful termination) and include harm caused to a person's property, personal well-being, and/or financial interests. For example, if a plaintiff is injured in an automobile accident caused by the reckless driving of the defendant, then the defendant may be required to pay an amount intended to place the plaintiff in the same position he or she would have been in had the accident never occurred. That is, the defendant may be required to pay the plaintiff's medical bills, lost wages (from missing work due to the accident), and an amount to cover the plaintiff's intangible pain and suffering. Compensatory damages do not include “punitive damages,” which are monetary damages intended to punish the defendant for intentional or grossly negligent actions.

In a breach of contract case, on the other hand, the party breaching the contract (the defendant) must pay damages to the nonbreaching party (the plaintiff) such that the plaintiff is in the same position he or she would have been in had the defendant not breached the contract (also known as giving the plaintiff the “benefit of the bargain”). In some cases, these damages include “consequential damages,” which are damages that are indirectly related to the breach of contract but are a foreseeable result of breaching the contract. This is demonstrated by the classic 1854 [Page 385]case of Hadley v. Baxendale. In that case, the plaintiff hired the defendant to take a broken crankshaft from his mill into town for repair. The defendant promised to return the crankshaft the following day, but the delivery was delayed for several days. During this time, the plaintiff was unable to operate his mill. The plaintiff filed a lawsuit seeking compensatory damages that would put him in the same position he would have been had the contract not been breached, which included the consequential damages of lost profit due to the mill being shut down for those additional days. In this particular case, however, the defendant was not required to pay the additional, consequential damages because it was not reasonably foreseeable that the entire mill would have to be shut down during his delay (i.e., the defendant may assume that there were other problems with the mill or that the plaintiff had an additional crankshaft). Had the shutdown of the mill been foreseeable, however, then the compensatory damages would include the lost profits.

Compensatory damages play a vital role in ensuring that actors invest in preventative measures efficiently. From a law and economics perspective, the goal of our tort system, for example, is to minimize the total costs of accidents (i.e., harm suffered) and actions to prevent accidents. Society is better-off if the costs of prevention are less than the costs of an accident occurring, but society is worse off if the preventative measures are greater than the benefits they provide. By requiring the defendant to compensate injured parties for the harm caused by their actions, the legal system provides incentives for actors to efficiently invest in preventative measures. Likewise, in contract law, requiring the defendant (the breaching party) to pay compensatory damages to the nonbreaching party allows for socalled efficient breach. Under the idea of efficient breach, if the defendant can benefit more from breaching the contract but also paying the plaintiff his or her expected “benefit of the bargain,” then we have reached a Pareto superior result. The concept of efficient breach is not without criticism, however. For example, it may often be the case that the plaintiff is not indifferent between a compensatory damages award and performance of the contract and, therefore, is made worse off by the defendant's breach.

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