Firm X has promised to deliver an order of industrial parts to firm Y. However, there is a small chance that firm X will have so many orders from customers that it cannot fulfill them all. If its order is not filled, firm Y’s profit will fall by $100,000. If customer demand exceeds capacity, firm X’s cost of fulfilling firm Y’s order might turn out to be anywhere between $50,000 and $150,000.
a. Consider a contract in which firm X must guarantee delivery to firm Y. Explain when and why such a contract leads to inefficient actions and outcomes.
b. Alternatively, suppose the contract has a penalty provision: If firm X doesn’t deliver, it pays a penalty of $50,000 to firm Y. Does this contract lead to efficient outcomes? Why or why not? What if the penalty for nondelivery is set at $100,000 instead?