Chapter 8 PROBLEMS in class.
Spud Co. is a dealer in potatoes. Chip Co. makes potato chips. On Monday, Spud and Chip enter into a
contract in which Spud agrees to deliver 100 bushels of potatoes to Chip on Friday; Chip agrees to pay
Spud $2.00 per bushel.
Spud’s cost of growing and delivering potatoes  $100.
Chip’s cost of converting potatoes into chips  $100, $25 of which must be spent on Friday morning before
the potatoes are delivered and which cannot be recovered if no potatoes arrive and $75 for converting.
If no potatoes arrive on Friday, Chip must wait until Monday to call around to alternative suppliers to
purchase potatoes. Using alternative suppliers would imply that $25 spent above that wasn’t recoverable
and needs to be reinvested on Monday, making the cost for covering chips $100 on Monday. The price of
potatoes on this “spot” market is $3.00 per bushel. The price of potato chips is $4.00 per bushel.
1) Assume that Chip paid for the potatoes at the time the contract was signed. Just before delivering the
potatoes to Chip at noon on Friday, Spud receives a frantic phone call from Babette, the chef at Chez
Babette. She has discovered that the potatoes she bought from someone else are rotten and she needs 100
bushels immediately to make her famous vichyssoise (a fancy name for cold potato soup) that weekend. She
is willing to pay $5.00 per bushel as she cannot wait till Monday to buy potatoes on the spot market.
Is breach efficient? Under what measures of damages will efficient breach be achieved?
Perform:
Spud Profits: 2*100 – 100 = 100
Chip Profits: 4*100 – 2*100(potatoes) – 100 (converting cost) = 100
Joint surplus: 200
Breach:
Spud profits: 5*100 (babette) + 2*100(chip) – 100 (cost) - Damages
Chip Profits: 4*100 – 2*100(spud) – 3*100 (spot) – 100 (converting) – 25 (reliance)
+ Damages
Joint surplus: 275
Is Breach Efficient? YES! In all cases the efficient outcome is to breach and each type of damages
encourages breaching.
Damages:
Restitution: 200
Reliance: 225
Expectations: 325 (225 covering the contracted $200 the reliance $25 and the $100
because Chip expected profits of $100)
2) What if Babette offers $3.00/bushel, is breach efficient?
Spud Profits: 2*100 – 100 = 100
Chip Profits: 4*100 – 2*100(potatoes) – 100 (converting cost) = 100
Joint surplus: 200
Breach:
Spud profits: 3*100 (babette) + 2*100(chip) – 100 (cost) - Damages
Chip Profits: 4*100 – 2*100(spud) – 3*100 (spot) – 100 (converting) – 25 (reliance)
+ Damages
Joint surplus: 175
Is Breach Efficient? ONLY UNDER EXPECTATIONS. WHY? It is efficient to perform and not
breach, but restitution and reliance encourage Spud to Breach, only expectations does not.
Damages:
Restitution: 200 (Spud’s profits are $200 so he’ll breach)
Reliance: 225 (Spud’s profits are $175 so he’ll breach)
Expectations: 325 (Spud’s profits are $75, so he will perform)
3) Now instead assume that Chip agreed to pay for the potatoes C.O.D. On Thursday, Chip is shut down
for health code violations and will not be able to reopen for two months while it renovates its production
facilities to bring them up to code. It therefore has no use for the potatoes to be delivered on Friday. If
Chip performs by taking delivery of the potatoes, they will go to waste. If Chip breaches, it will refuse to
accept delivery. Spud, as dealer, can sell the potatoes to someone else for $1.50 a bushel.
Is breach efficient? Under what measures of damages will efficient breach be achieved?
Perform:
Spud Profits: 2*100 – 100 = 100
Chip Profits: 0 – 2*100 = -200
Joint surplus: - 100
Breach:
Spud profits: 1.50*100 – 100 + Damages = 50
Chip Profits: 0 - Damages
Joint surplus: 50
Is Breach Efficient? YES all are because all lead to breach.
Damages:
Restitution: 0
Reliance: 0
Expectations: 50
4) Still assuming Chip Co. is shut down for health violations, but now instead Spud Co. spends money in
reliance on the contract. Suppose that Chip Co. is in a location that is hard to find. Of Spud’s delivery
costs, $10 is spent getting precise directions over the phone from Spud and communicating these to the
delivery person. The remaining costs of production and delivery are $90. The total cost of production and
delivery is therefore $100.
In this variation, Chip Co. can take the following steps to minimize or eliminate the risk of being shut down
for health code violations.
Level of Precaution
Prob. of Shut Down
Cost of Precaution
1
50%
$ 0
2
10%
$50
3
0%
$75
If Chip gets shut down by the health officials, Chip will breach the contract, in which case Chip’s cost will
equal expenditure on precaution plus damages to Spud. If Chip breaches, Spud will lose the $10 invested
in specific directions to reach Chip and then Spud will pay $100 in production and delivery costs for potatoes
selling for $150. Under which measure of damages (restitution, reliance, and/or expectation) will Chip Co.
engage in efficient precaution?
Perform (no shutdown)
Breach
Expected Profit
Spud
Chip
(note: since COD, I am listing
cost paid first)
-100+200 = 100
-100 – 10 +150 = 40
1
-100 – 200 - 0 + 400 = 100
0 (cost of precaution)
120 = ½(100 + 100) + ½
(40+0)
2


-50 (cost of precaution)
134 = .9(100+50) + .1 (40
– 50)
3
-100 – 200 – 75 + 400 = 25
NA (no breach)
125 = 100 + 25
Expected joint profit
Level 1 = ½ (200) + ½ (40) = 120
Level 2 = .9 (150) + .1(-10) = 134
Level 3 = 125
Level __TWO_____ is the optimal level of precaution because it leads to highest level of expected
profits.
Chip’s precaution decision: Level 1 profit = ½ 100 + ½ (0) – ½ Damages = 50 – ½ Damages
Level 2 profit = .9*(50) + .1 (-50) - .1Damages = 40 - .1Damages
Level 3 profit = 25
Damages:
Restitution $0; level 1
(50 > 40 > 25)
Reliance: $10; Level 1
(45 >
Expectation: $60; level 2  only efficient level