1. Imagine that there 1s a set of soft drink producers who would like to buy the services of a bottling company, A. The maximum price that any of these companies 1s willing to pay for the services of A 1s v = 20,000 euros per day. A's operating costs are = 25,000 euros per day. Company X, one of the potential customers, proposes A the possibility to carry out a specific investment in a new bottling technology. The fixed costs of amortization of this investment 1s a = 30,000 euros per day and 1t can be rented for an alternative use for 5,000 euros per day. If it is rented, it cannot be used by X. If it 1s used by X, it cannot be rented to a third party. Once the specific investment has been made, the services company A has a value of v '= 75,000 euros a day for company X, but still have a maximum value of 20,000 euros per day for the remaining companies. Unless specified otherwise, the price is set equal to the willingness to pay. (Throughout the whole exercise we suppose that all agents are risk neutral). a) Assume that Company X promises the Company A a price of 50,000 euros per day (p'= ( + v ") /2=50.000). That price, and the pricing rule, only applies to a sale to the specific buyer. Also assume that Company A has full confidence in the promises of company X. In this case, will Company A undertake the mvestment? b) What if Company X offered Company A 70,000 euros per day (p''=70000)? (The assumption that company A fully trusts company X 1s maintained). ) If Company X behaves opportunistically after the investment has been undertaken, what price would it offer for the services of A? What would then the revenue of A be? d) What possible solutions exist to reduce the risk of opportunistic behavior? Explain your answer. 2. Imagine a small Belgian town in which several manufacturers of artisanal chocolate operate. In the town, the company "Eiffel" manufactures boxes of sweets and chocolates. The artisans are willing to pay for the services of this company 200 euros a day and, if it produces, Eiffel's operating costs are 250 per day. One of the craftsmen asks Eiffel to make boxes with his own brand and logo, which would require that Eiffel makes an investment whose repayment costs are 300 euros per day. If Eiffel makes this investment the artisan would be able export his chocolates so that the services would have a value of 750 euros a day for him (the rest of artisans would still be willing to pay 200 euros a day). Unless specified otherwise, the price is set equal to the willingness to pay. We assume that agents are risk neutral. a) Suppose that being a small city where all the inhabitants know each other, Eiffel trusts the craftsman's promises. If the craftsman promises Eiffel a price of 500 euros a day, will the investment take place? b) Would the investment be made if the craftsman offered 700 euros a day? (We still assume that Eiffel trusts the craftsman). c) If the artisan decided to behave opportunistically, what price would he offer for Eiffel's services once the investment was made? What would be Eiffel's profits? 3. Suppose that when you finish your undergraduate studies you receive an offer from the legal and economic consultancy AJE that 1s specialized in advising telecommunications companies in Lalaland. The offer 1s as follows: AJE would like to hire your services so that it could advise the telephone company of Lalaland, but previously you must do a specially designed Master course that includes specific training on the telecommunications sector in this country. The Master lasts a year. This course constitutes a strong specific investment in human capital for you since no other company works on this project. Thus, the skills that you acquire would have no values for employers other than AJE. During the course year, you would not receive any salary, but AJE's director AJE promises to hire you once you finish the course. The job would be for a year, receiving a compensation of 60000. Once the offer 1s made, you consider the convenience of studying the course. If you do not, you can look for any other job in the market and given the experience of your colleagues from previous years you expect to find work that year with a 75% chance and get a salary of 20000 / year during the first year and 30000 / year during the second year. If you cannot find a job that year, you get an income equal to zero. The following year, you will have a 50% chance of finding a job (smce the market 1s valuing negatively the fact that you were unemployed for a year) and you expect to get a salary 20000 / year during that second year. (To sumplify the analysis, we assume that your market value and your chances of finding a job for the third year are independent of your decisions during these first two years) a) Suppose that you are risk neutral and the future has the same value for you as the present so that your profit is equal to the sum of the payments in the two periods. If you believe 1n the offer of the company AJE, what decision will you make? b) Would your decision change if you were risk adverse? (Reason your answer intuitively) c) Suppose now that you have doubts about the credibility of AJE since you do not know its reputation n the market. Your a prior1 expectations on the behavior of AJE are the following: 60% of AJE like firms are honest and keep their promises, while the remaiming 40% allege financial problems and the bad economic situation of the country and end-up offering a remuneration equal to what you could be expected to obtain in the market working for another company, that 1s, 20K. d) Suppose now that your prior 1s that the probability that AJE 1s honest 1s 40% (and 60% that it 1s not honest). Would you do the master