Deck 10: The Economics of Contracts

Question 1

Incompleteness of a contract can be considered boundedly rational if at the time the parties draft the agreement they do not know how they can best react to certain contingencies.

Answer 1

True

Question 2

Which of the following examples can be associated with the task specificity aspect of an asset?

A)An employer's investment in employee skill building.
B)Purchasing machines which can be used to produce only a particular product.
C)Building a facility in a low cost locality.
D)An employer's investment in office renovation.

Answer 2

B

Question 3

A contract may remain incomplete because the expected benefits of greater completeness do not cover the costs of drafting it.

Answer 3

True

Question 4

An organization offers training programs for its employees at a subsidized rate to help them use a nascent technology that the organization is adopting.The trained employees later bargain for a higher wage from the management as their probability of finding better paying jobs increase because some other companies are also adopting it.This action of the employees is an example of:

A)selfishness.
B)holding up.
C)opportunism.
D)specificity.

Question 5

The inability of client to monitor the efforts made by his lawyer to defend his case is an example of the principal/agent problem.

Question 6

A capitation arrangement between the plaintiff and the defendant in a lawsuit helps to reduce the problems of monitoring and uncertainty associated with a principal/agent relationship.

Question 7

If liquidated damages stated in a contract are too low, inefficient breaches will be profitable, and if damages are too high, efficient breaches will not occur.

Question 8

A packaged fruit juice manufacturer contracts with several farmers to buy their orchards to support a new production facility.However, a particular orchard owner later refuses to sell his farm at the price in their contract.In such a case the court will order a liquidated damage.

Question 9

Suppose Jerry and Joseph are two tenants sharing an apartment having a private lawn.They have agreed to share the costs of cleaning and maintaining it.Jerry would be considered an opportunist if he plants some flowers in this lawn at his own expense without consulting Joseph.

Question 10

Which of the following investments can be classified as specific assets?

A)Opening a restaurant in the business district of a city.
B)Purchase of additional cotton bales expecting a rise in demand for cotton garments.
C)Leasing out land in a tourist spot to build a retail outlet.
D)Purchasing specialized equipment for a hydro-electric power project that will not produce electricity at a different location.

Question 11

Under a principal/agent relationship, the agent faces high costs of determining whether the principal is actually making efforts to the extent the agent expects.

Question 12

If each of the parties to a contract controls a resource essential for the other's survival, opportunistic behavior by any of them will increase the value of the transaction.

Question 13

Suppose Bella had entered into a contract to rent Michelle's apartment for one year.The contract mentioned that if either of the two parties breached it, the other was to recover her loss.If Michelle breaches the contract, a payment which leaves Bella no worse off than if the contract was honored, is called opportunistic damage.

Question 14

The parties to a contract usually try to minimize the risks of costly opportunistic behavior by putting appropriate provisions in it.

Question 15

Which of the following contracts is considered self-enforcing?

A)An assurance provided by a lawyer to his/her client to win a case.
B)A futures contract purchased through a NYSE broker.
C)An agreement between two oligopolists to follow uniform pricing strategy.
D)An agreement between two students to share assignment responsibility.

Question 16

Which of the following is true of opportunism?

A)Opportunism increases the possibility that a party can gain by disregarding the contract.
B)Opportunism lowers the cost of negotiation between parties when the contract is incomplete or unclear.
C)Opportunism allows parties to maximize the value of their transactions.
D)Opportunism leads to mutually beneficial outcomes.

Question 17

Economic value of a transaction where the buyer is allowed to deal with several sellers at the same time will always be higher than a transaction which ties the buyer to a particular seller by contract.

Question 18

Asset specificity means lower costs of redeployment and lower risks of opportunism associated with a contract.

Question 19

Sam, a fish wholesaler, entered into a contract with a department store to supply herring at a price of $2.50 per pound for a year.When a hurricane closed most fisheries Sam increased the price to $3.25 per pound and refused to sell at the old price.Sam's behavior is an example of opportunism.

Question 20

Maximizing the benefits of a transaction made under a contract often requires specific investments that lose value if the parties fail to fulfill their commitments.

Question 21

The matrix given below represents the payoffs to oil well owners Mike and Frasel if they enter into a unitization contract.Each of the owners know the exact amount of oil in the pool and the market price of oil.
Table 10-1

Refer to Table 10-1.Under expectation damages, Frasel's breach of the contract would lower his net payoff to:

A)$6.
B)$8.
C)$16.
D)$10.

Question 22

According to the Coase theorem, if transactions and negotiations are costless:

A)people would arrive at agreements that maximize their individual benefits.
B)people would arrive at agreements that maximize the total economic value.
C)people would arrive at agreements that minimize their individual costs.
D)people would arrive at agreement that minimize the total social cost.

Question 23

If parties to a contract can anticipate the court's decision in the event of a dispute with some degree of certainty:

A)opportunistic behavior will never be detected.
B)opportunistic behavior will be partially detected.
C)there will be less room for opportunism.
D)only one of the parties will be able to act opportunistically.

Question 24

In which of these situations is vertical integration most likely?

A)A cargo distribution company's vertical integration into storage.
B)An airline's vertical integration into aircraft design and manufacture.
C)A coal miner's vertical integration into thermal power generation.
D)An airline's vertical integration into food production.

Question 25

The matrix given below represents the payoffs to oil well owners Mike and Frasel if they enter into a unitization contract.Each of the owners know the exact amount of oil in the pool and the market price of oil.
Table 10-1

Refer to Table 10-1.Under expectation damages, Mike's breach would entitle Frasel to:

A)a $10 payment from him.
B)a $16 payment from him.
C)a $8 payment from him.
D)a $6 payment from him.

Question 26

An automobile manufacturer imported equipment in order to produce a particular model at low cost.Falling demand, however, forced it to cease producing that model, and the company took a large loss because the equipment was not usable for producing other models.The equipment was characterized by:

A)locational specificity.
B)dedicated specificity.
C)human specificity.
D)task specificity.

Question 27

Assume that James owns a wheat farm that produces an annual crop of 500 bushels.His only choice is to store it in a nearby grain elevator owned by Martin, whose facility will be empty unless James is using it.Martin contracts with James to provide storage at $5 per bushel every month.In this example James and Martin are in:

A)probabilistic positions.
B)asymptotic positions.
C)hypothetical positions.
D)symmetric positions.

Question 28

The matrix given below represents the payoffs to oil well owners Mike and Frasel if they enter into a unitization contract.Each of the owners know the exact amount of oil in the pool and the market price of oil.
Table 10-1

Refer to Table 10-1.If Mike has to pay Frasel expectation damages what would be his net payoff from the breach?

A)$8
B)$10
C)$0
D)$6

Question 29

Which of the following is a legal remedy for a breach of the contract between parties?

A)Liquidated damages
B)Imprisonment
C)Unitization
D)Specificity

Question 30

The matrix given below represents the payoffs to oil well owners Mike and Frasel if they enter into a unitization contract.Each of the owners know the exact amount of oil in the pool and the market price of oil.
Table 10-1

Refer to Table 10-1.What would be the combined gain of the two if both breach the unitization contract?

A)$22
B)$20
C)$28
D)$32

Question 31

Which of the following features was prominent in the airline industry during the 1950s?

A)The airlines had to concentrate on cost reduction.
B)The airlines had to lower the frequency of flights to meet rising costs.
C)The airlines served food prepared by their own employees or by other airlines.
D)The airlines industry was revolutionized by low-cost budget airlines.

Question 32

The matrix given below represents the payoffs to producer Hansel and purchaser Gretel from a transaction.Hansel is the producer of Good X and Gretel is the purchaser.Assume that Gretel has no incentive to break the contract.
Table 10-2

Refer to Table 10-2.Under expectation damages, if Hansel breaches the contract he would have to pay Gretel:

A)$10.
B)$5.
C)$8.
D)$3.

Question 33

Which of the following can be classified as a highly specific asset?

A)A country's soldiers
B)A wind turbine in an installation that produces "renewable" electricity
C)A cattle farm
D)A cruise ship

Question 34

Which of the following is an example of vertical integration?

A)An industrialist building new plants in a country where operation costs are low.
B)A cosmetic company collaborating with worldwide retailers to market its product.
C)A fruit juice manufacturer purchasing orchards.
D)An exporter delivering goods at a contracted price.

Question 35

A travel agency enters into a contract with a hotel chain which gives it priority access to 25 percent of its rooms in major tourist destinations throughout the year.The contract encourages the hotel chain to increase the number of rooms in each of these hotels.The investment made by the hotel chain corresponds to which of the following aspects of specificity?

A)Task specificity
B)Locational specificity
C)Dedicated specificity
D)Human specificity

Question 36

Suppose Jonah and Carlos have a contract, which Carlos chooses to breach. Jonah sues, and a court orders Carlos to pay him the amount he expected to gain at the time they made the contract, net of any amount he actually did receive after the breach.The form of payment which the court specifies in this example is called:

A)a contingent fee.
B)a specific performance.
C)a capitation.
D)expectation damages.

Question 37

The matrix given below represents the payoffs to producer Hansel and purchaser Gretel from a transaction.Hansel is the producer of Good X and Gretel is the purchaser.Assume that Gretel has no incentive to break the contract.
Table 10-2

Refer to Table 10-2.What would be the total economic value of the transaction if both of them keep the contract?

A)$10
B)$16
C)$15
D)$30

Question 38

_____ is an example of human specificity which raises the risks associated with opportunism.

A)Car insurance purchased by an individual for his/her favorite car.
B)Investment of an employer in company-specific skills.
C)Purchasing immovable machines for a particular facility.
D)Investment in research and development

Question 39

Fixing a payment schedule in an agreement:

A)allows the seller to easily access loanable funds.
B)increases the uncertainty associated with the cost of production.
C)allows the seller to charge a high price for his product.
D)ensures the delivery of goods at a high price.

Question 40

The matrix given below represents the payoffs to oil well owners Mike and Frasel if they enter into a unitization contract.Each of the owners know the exact amount of oil in the pool and the market price of oil.
Table 10-1

Refer to Table 10-1.What would be the combined gain of the two owners if they maintain the unitization contract?

A)$22
B)$28
C)$20
D)$0

Question 41

Which of the following is an example of a principal/agent relationship?

A)Banks lending money to start-up companies.
B)An investment banker investing the client's money into different securities.
C)Advance booking for a car after watching its promos at a car show.
D)Investing your money in fixed-return deposits and government securities.

Question 42

_____ is an arrangement between an attorney and the plaintiff, in which the latter agrees to pay a certain fraction of the money he/she wins to the former.

A)Hourly billing
B)Capitation
C)Contingency
D)Unitization

Question 43

Which of the following may require the parties to renegotiate certain parts of a contract if market conditions change drastically?

A)Termination clause
B)Omnibus clause
C)Adjustment clause
D)Reopener clause

Question 44

Which of the following will be an efficient payment scheme for a defendant's attorney, who is experienced in handling similar cases in the past?

A)Contingency fees
B)Capitation fees
C)Hourly billing
D)Quality based billing

Question 45

How does opportunistic behavior affect a contract?

Question 46

The matrix given below represents the payoffs to producer Hansel and purchaser Gretel from a transaction.Hansel is the producer of Good X and Gretel is the purchaser.Assume that Gretel has no incentive to break the contract.
Table 10-2

Refer to Table 10-2.Will breaching of the contract be an efficient outcome?

A)Yes, because Hansel will earn $12 after paying expectation damage and Gretel will remain as well off as under the contract.
B)No, because Hansel will earn $5 after paying expectation damage and Gretel will remain as well off as under the contract.
C)Yes, because both Hansel and Gretel will remain as well off as under the contract and Gretel's earnings will increase.
D)No, because Hansel will remain as well off as under the contract and Gretel's earnings will fall.

Question 47

Parties to the contract prefer to keep the actual agreement incomplete when:

A)they have conflicting terms and conditions.
B)they are large in count.
C)the economic value of the contract is low.
D)the cost of negotiation is high.

Question 48

Provisions that allow the contract price of a commodity to change with changes in its market price are referred to as:

A)omnibus clauses.
B)escape clauses.
C)adjustment clauses.
D)exclusion clauses.

Question 49

_____ is a contract that specifies actions to be taken if various situations come to prevail.

A)An insurance policy
B)Contingency
C)Unitization
D)An escalator

Question 50

Which of the following exemplifies specific performance that a court might order from the party in breach of a contract?

A)A seller ordered to pay back the price of the commodity to the customer having failed to deliver it on-time.
B)A popular singer requested to forgo the fee for her performance at a social fund raising program.
C)The owner of a polluting factory ordered to convert his private plot into a public garden.
D)A movie director ordered to work with an actress he had previously contracted with, instead of one he later found was available for a lower price.

Question 51

Which of the following is true about specific performance?

A)It is an amount paid by a breaching party to the suffering party to cover the latter's loss.
B)It arises in situations which involve written promises.
C)It is usually ordered by the court when the economic value of the transaction is difficult to quantify.
D)It is common in case of contracts having a negative influence on the society as a whole.

Question 52

Mention the different aspects of specificity of an asset.

Question 53

Which of the following is NOT true of an incomplete contract?

A)It discourages parties from acting opportunistically.
B)It increases the cost of negotiation.
C)It allows renegotiation among parties if certain events occur.
D)It contains provisions for terminating the contract if certain events occur.

Question 54

Under which circumstances does vertical integration become useful?

Question 55

The matrix given below represents the payoffs to producer Hansel and purchaser Gretel from a transaction.Hansel is the producer of Good X and Gretel is the purchaser.Assume that Gretel has no incentive to break the contract.
Table 10-2

Refer to Table 10-2.If the law requires Hansel to pay $10 to Gretel for breaching the contract:

A)Hansel would breach the agreement even when economic efficiency requires him to keep the agreement.
B)Hansel would abide by the agreement even when economic efficiency requires that he breach it.
C)Hansel would abide by the agreement and total economic value of the transaction will be maximized.
D)Hansel would breach the agreement and total economic value of the transaction will be maximized.

Question 56

A payment arrangement between an attorney and a plaintiff, in which the plaintiff agrees to pay a certain lump-sum amount at the outset and no more in the future, regardless of how the case develops is called:

A)contingency fees.
B)capitation fees.
C)liquidation.
D)one-time settlement.

Question 57

How do buyers and sellers benefit from a contract?

Question 58

What are specific assets?

Question 59

Escalators present in a contract must state:

A)at what interval the contract price should automatically change at a fixed rate.
B)when the price will change and by what formula the new price will be calculated.
C)when the contract should be terminated and how the cost of termination should be shared.
D)when the contract should be renewed and the terms governing the renewal.

Question 60

Which of the following is a problem encountered in a transaction involving a principal/agent relationship?

A)Absence of monitoring and supervision
B)Excessive dependence on forecasts and expectations
C)High investment in industry specific assets
D)Government interference and market volatility

Question 61

When are liquidated damages required? Describe with an example.

Question 62

What does an efficient payment scheme in a principal/agent relationship depend on?

Question 63

What kind of a payment provision should a contract governing a principal/agent relationship contain?

Question 64

When does an incomplete contract prove beneficial?

Question 65

When should parties be allowed to breach a contract?

Question 66

How can an incomplete contract prevent opportunism? Explain with an example.

Question 67

Explain the concept of liquidated damages with an example.