Question

Consider a buyer and seller who enter into a contract where the seller produces a good and delivers it to the buyer for payment. At the time of making the contract, the seller is uncertain as to the actual cost of the project, and the situation is described by the following:

Cost = 30 with probability 60%

Cost = 70 with probability 20%

Cost = 150 with probability 20%

Before production occurs, the seller does learn the cost. The value of performance to the buyer is 100.

a. Initially, consider a contract under which the seller is expected to perform regardless of the realized production cost. The buyer agrees to pay 75 on delivery. Assume that the parties both follow the contract (no breach occurs). What is the expected gain from the contract to each party? Demonstrate that a contract exists that specifies performance only when the cost is 30 or 70 which is preferred by both parties at the time signing the contract.

b. Suppose the contract specifies a price of 50 and the seller is only expected to perform when the cost is 30. Assume that the parties both follow the contract. What is the expected gain to each party from this contract. Demonstrate that a contract exists in which the seller performs when the cost is 70 and 30 that both parties prefer.

c. Suppose now that the contract simply states “seller shall perform” as in the contract from part (a) in exchange for some price. Show that with perfect expected damages for breach, the contract is efficient (e.g. Pareto Optimal). What range of prices would the buyer and seller agree to?

Answer 1