Contracting with Imperfect Information
The manufacturing firm marginal benefit, MB, for hours of legal service is
MB=$400-2L, where L=hours per week of legal services.
Marginal benefit represents the maximum price that a rational buyer would pay for an additional unit of anything. This means that the marginal benefit curve can be considered to be the demand curve. This curve can be represented on a graph by figuring out the end point and then drawing a straight line between these points.
For this case, we will take the formula MB=$400-2L, where L represents hours of legal services. The first step is to find out the value of MB when L=0 (this will give the value $400-0, therefore the vertical intersection point is $400) and when the value of MB=0, the value of L will be (0=400-2L L=200). For this question there are no fixed costs and the marginal costs (MC) is constant and equal to $200 per hour of legal services (L). For this case, the most efficient outcome would be to have the law firm supply legal services up to the point where the marginal cost is equal to the marginal benefit. This means that the law firm will supply a total of 100 hours of legal services.
Therefore, the total cost to the law firm would be $20,000 and surplus from providing this services would be $10,000. This is shown in the diagram below.
If we assume that the law firm ends up supplying 100 hours. If the law firm has all the market power and is able to dictate terms to the manufacturing firm, then the law firm might simply bill the tire company a total of $30,000 for 100 hours of legal services. In this case, the law firm would keep all the surplus of $10,000. The law firm would essentially be acting as a perfectly discriminating monopolist. The outcome is the same as what you would get by having the law firm charge a different price for each hour of service. If the law firm has all the power along...
…case, the law firm will need to incur bonding costs worth $800 and the client will need to have someone to monitor and liaise with the law firm. In this example, it is assumed that this will cost the client $800. The combined monitoring and bonding costs would then be equal to $1600 split between the two parties. Note that in this case the monitoring and bonding costs would be equivalent to $40 per hour of legal services. This is essentially equivalent to an increase in the overall marginal cost from $200 to $240. Note that this increase in cost will lower the optimal amount to be provided from 100 to 80 units. Moreover, the surplus available to split between the two parties has now shrunk from the $10,000 in the case of full information to $6400. This is shown in the diagram below:The remaining $6400 surplus will be split between the two potential trading partners would depend on the relative bargaining strength of the two and upon what kind…
References
Brickley, J. (2016). Managerial Economics and Organizational architecture (6th ed., pp. 356-376). McGraw-Hill Education.
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