Baxendale runs a shipping company and can ship his clients packages via either the U.S. Postal Service or Federal Express. Shipping by USPS costs $20, but there is a 1 in 50 chance the package will be a week late. Shipping by FedEx costs $50, but there is no chance the package will be late. Suppose that for three-quarters of Baxendales clients, a weeks delay would cause $1,000 worth of inconvenience; for the other quarter, the package is urgent, and a weeks delay would cost $5,000.

a) What is the efficient means of shipping for an urgent package? For a non- urgent package?

b) Suppose Baxendale cant tell whether a particular package is urgent or not. The expected value of a weeks delay is therefore $2,000. If expectation damages are based on the actual cost of delay, what would he choose to do?

c) A different rule would hold Baxendale liable for only $1,000 in the event of a delay, unless the client specifically told him the package was urgent. Explain why this could be referred to as a penalty default, and what outcomes you expect it to lead to.