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Answers to Back-of-the-Chapter Problems
1. a. The plaintiff’s expected court receipt (net of legal costs) is 50,000 - 15,000 =
$35,000. The defendant’s expected court payment (including legal costs) is
50,000 + 15,000 = $65,000. The zone of agreement lies between these two
b. When the potential damages are $200,000, the expected court outcomes of the
c. Facing a nuisance suit, the defendant knows it will win its court case but still
faces an expected cost equal to its legal fees. Thus, it rationally might settle
2. a. When the firm’s profits are booming, management is vulnerable to a costly
c. With high unemployment, labor has more to lose from a prolonged strike.
3. Paying the developer 1 percent of the store’s first year’s revenue might be
beneficial for two reasons. First, if the parties are risk averse, this arrangement
4. a. No. Attaining zero percent defects is very costly for firm S who will insist on
b. The value-maximizing agreement calls for 4 percent defects. Here the
5. a. Since the mill has the right to pollute, the fishery must pay it to clean up. With
50 percent cleanup, the benefit to the fishery is 100,000 - 30,000 = $70,000.
b. The same 50 percent reduction would be negotiated if the fishery held the
legal right to clean water. Moving from 100 percent cleanup to 50 percent
cleanup costs the fishery $30,000 in reduced profit, but saves the mill $50,000
6. a. As a general rule, an outcome on an issue should be adopted if and only if
doing so increases the value of the contract to the parties together. The table
UMW Producers Parties Together
Clauses
Introducing the right-to-strike clause has a negative (-$20 million) impact on
the parties together. Since it reduces total value, it should not be introduced.
Opening non-mine jobs increases total value (management’s gain exceeds
b. Now it is impossible to introduce a single clause, since a compensating wage
change is ruled out. Besides the status quo, the only other option is to
introduce both clauses. Is this mutually beneficial? The table shows that each
7. a. The eight possible agreements (and associated payoffs) are
1. 95%, 3yr, w/o Bio.: 180, -140 2. 95%, 5yr, w/o Bio.: 100, -80
8. a. Company A’s expected value for company is (.5)(50) + (.5)(20) = $35 million.
b. A 100% stock transaction (at the right terms) works because it allows
Company A to pay a 50% depreciated price in the event of liability.
Effectively, Company A pays a contingent price. For instance, suppose
c. A buyback provision makes good sense because if Company T is liable, the
firm will be worth more under T’s management ($30 million) than under
*9. The buyer’s expected profit is b = (vb - P)F(P). The buyer determines the
optimal price P that maximizes this expression by setting marginal profit
10. If firm A claims 55%, its expected profit is (.9)($110,000) = $99,000. If it
*11. The value of the target under current management ranges between $60 and
$80 per share, with an expected value of $70 (since all values are equally
likely). What if Firm A offered a price of $70? Current management accepts
this price when vT is between $60 and $70. (Obviously, if vT > 70, Firm T
12. a. Presumably, Icahn has the first move (whether to spend $50 million to launch
a dissident campaign). Such a campaign costs AOL $200 million, so the zone
of agreement has AOL paying an amount of greenmail somewhere between
these two values. The best prediction is that Ichan will initiate an opposition
b. The efficient outcome is an AOL-Microsoft partnership (with total value $500
c. The firms’ different views about the source of value can definitely impede a
deal. For instance, it is perfectly possible that each side thinks that it is
responsible for 70% of the $250 total value and, therefore, deserves such a
Discussion Question
Negotiation and litigation can be thought of as opposite ends of the dispute
resolution spectrum, with mediation and arbitration in between.
Negotiation is private, voluntary, informal, and (usually) low cost. The
Litigation is public, imposed, formal, and costly. Via an adversarial process
Under mediation, a third-party is assigned to help the disputants reach their own
agreement. The mediator can play many roles:
However, the mediator cannot impose an agreement or bind the parties to one. If
mediation fails, the parties can pursue arbitration or litigation.
Under binding arbitration, the disputants present their cases to a third-party who
imposes the final outcome. The arbitrator (usually an expert in the area of
In short, mediation is a close cousin of negotiation, while arbitration is meant to
Spreadsheet Problem
S1. a. and b. To find one end of the zone of agreement, we use the optimizer to
maximize Company B’s profit in cell L13 by changing the dummy variables
(cells C7, C9, C12, C13, C14, I7, and I9) and the payment in cell H13,
subject to Company U’s profit in cell K13 being equal to zero. In addition,
c. We see that the low-quality, full-warranty, 5-year contract is efficient. The
