law of economics (solve this problem)

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Question description

1. CMI, a manufacturing company, wants to build a new plant. It could hire Five Cities construction to build the plant for a price of 3 million dollars. Five Cities believes, based on projected costs for labor and materials, that it would cost 2.8 million to do the project. CMI estimates, based on projected demand for its product, that the net present value of the plant upon completion would be 3.2 million.

a. If there were no penalties for breach of contract, would CMI make this deal with Five Cities? Explain. Would your answer differ if you were told that Five Cities had built many things for CMI in the past, and expected to have opportunities to do so in the future as well?

b. Suppose that contracts are enforced, and the court awards expectation damages if there is a breach. If Five Cities took the money and then failed to perform, what would they have to pay to CMI? Explain why a secure expectation that the court would enforce the contract would lead CMI to be willing to make the deal.

2. After the contract is made, the prices of some key construction materials rise higher than Five Cities anticipated, so that the cost to them of building the plant rises to 3.05 million. Again supposing that contracts are enforced with expectation damages, will Five Cities breach? Would it be socially optimal for them to breach? Explain.

3. For this question, assume that Five Cities is a wholly owned subsidiary of CMI, that is, they are both run by the same management. In conjunction with building the plant, CMI can make a number of investments prior to the start of construction to increase the potential value of the completed plant. The possibilities for such investment are given below:

If CMI invests an additional:

The value of the plant will rise to:

.04 million

3.24 million

.11 million

3.315 million

.12 million

3.316 million

Also, the CMI management knows that construction costs for its Five Cities subsidiary may rise. There is a 75% chance that the cost of building the plant will be 2.8 million, and a 25% chance that it will be 3.29 million.

Assume that the goal of CMI/Five Cities management is to maximize expected profit (value of plant minus expected cost of building and additional investment). Note that they have four levels of additional investment they can choose (none, .04, .11, or .12 million), but must make this choice before they know the cost of construction. Note also that they may decide not to build the plant if construction costs turn out to be high, but will still lose the value of any additional investments, which have to be made before construction starts.

a. What will CMI’s optimal strategy be? That is, what level of additional investment will they choose, and will they actually build the plant if cost of building is high? Remember that expected profit for a strategy is .75 X (profit if construction costs are low) + .25 X (profit (or loss) if construction costs are high).

b. Assuming that CMI operates in a competitive market, the strategy chosen by CMI is the socially optimal one. Explain how we know this.

4. Assume all the facts are the same as in question 3, except assume once again that Five Cities construction is a separate company from CMI, and has signed a contract to do the construction project for a payment of 3 million.

a. Suppose both parties know that the remedy for CMI in case of a breach will be a payment equal to the value of the unbuilt plant, where that value is determined based on whatever reliance investments CMI might have made (For example, if CMI invested an additional .04 beyond the 3 million it paid Five Cities, then in the event of breach Five Cities would have to pay 3.24 million to CMI – that is, return the 3 million it got from CMI plus the .04 that CMI invested in reliance plus .20 million that CMI expected in profit). Under these circumstances, what level of reliance investment would CMI undertake? If the costs turned out to be high, would Five Cities breach or perform? Explain.

b. The socially optimaloutcome in this question is the same as in question 3, but in this question’s scenario the decisions made about how much to invest and whether the plant is built under various circumstances are different from the decisions made in question 3.What causes the socially sub-optimal decisions to be made in this scenario?

5. A business concern hosted a lunch for a large group of potential clients. They hired a caterer for $400, paid in advance. This caterer was the low bidder for the job – the next lowest bidder was $450. On the day of the lunch, the caterer did not show up on time because of a combination of a problem in their kitchen, a mechanical problem with a truck, poor decisions by employees, and bad traffic. The business was forced to order pizzas and soft drinks for $250 to feed their guests. The business sued the caterer for damages, arguing that the lack of a high quality lunch at the event led many potential clients to have a bad impression of the company, which would cost the company business down the road.

a. Is specific performance a reasonable remedy in this case? Explain.

b. What major problem would face the court if it wanted to impose expectation damages in this case?

c. If it could be determined that the business lost profits of $700 as a result of serving pizza instead of the catered lunch, calculate the level of expectation damages, opportunity cost damages, reliance damages, and restitution damages in this case. 

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