Reference no: EM13880168

Firm B and firm S are in the process of negotiating a contract whereby S will synthesize a hormone for B. Besides the payment from B to S, three issues are involved: (1) whether the hormone will be 95 percent or only 80 percent pure, (2) whether the target date for completion will be three or five years, and (3) whether B will lend two of its expert biochemists to S to aid in the development. Firm B has estimated its values for various combinations of issues, and firm S has estimated its costs. These amounts are shown in the table.

B's Values                                               S's Costs

95%	3 Years 180	5 Years 100	3 Years 140	5 Years 80
80%	160	60	90	50

 

No biochemists	0	0	0	0
Biochemists	-30	-30	-40	-20

 Lending the biochemists is purely an additive factor; doing so reduces B's value but also reduces S's cost. For example, a three-year contract for a 95 percent pure hormone with the loan of the biochemists has a value to B of 180 - 30 = 150 and a cost to S of 140 - 40 = 100.

a. With three issues (two outcomes each), there are eight possible contracts. Which contracts are inefficient (i.e., produce worse outcomes for both sides than some other contract)?

b. Given that dollar-for-dollar compensation can be paid between the parties, which of the eight contracts is optimal? Explain.