You discovered a drink recipe which increases short-term brain activity. You call it the SuperComm drink. The drink is extremely popular among your fellow students, as it allows them to substantially cut down their studying time while still doing great on their exams. You keep the recipe secret and want to profit by manufacturing and selling the SuperComm drink. You plan to sell 1,000 drinks a month at the price of $5 per drink. The cost of ingredients per drink is $0.50. Additionally, you have to pay the start-up cost of advertising of $100. Your friend Steve has agreed to bottle the drinks for you. You promised to buy 1000 bottled drinks from Steve at $1.50 per bottle (drink). Steve buys bottles at $0.20 per bottle. In addition, Steve spent $500 on a machine which seals bottles. The bottling machine has no resale value.

(a) What is your relationship-specific investment (assuming your advertising is not specific to your business with Steve)? What is Steves relationship-specific investment?

(b) Assume you and Steve are doing business on the agreed terms. What is your rent (profit)? What is Steves rent (profit)?

(c) If your agreement with Steve falls through, your second-best alterative is to partner with your other friend, Joel. Joel will do business with you if you pay him $3.50 per bottle. What is your quasi-rent?

(d) Steves second-best alternative is to exit the bottling business. What is Steves quasi-rent?

(e) Whose bargaining position is stronger? Why?

(f) Suppose your agreement with Steve falls through. Steve asks you to pay him $3.00 per bottle, or else he quits working with you. Will you accept Steves offer?

(g) Is there a hold-up in this case, and is the outcome inefficient?

(h) How much do you need to pay Steve to ensure that your bargaining positions are the same?

(i) Intuitively, how would your answer to the question (h) change if the resale value of the bottling machine were $200, rather than zero? Would your pay to Steve that equalizes your bargaining positions fall or rise and why? Provide an intuitive answer, without any calculations.

(j) What if Steve does not trust you? He thinks that as soon as he purchases the bottling machine, you will reduce your payment to him to $0.40 per bottle. Would he still buy the bottling machine? Does this hold-up problem lead to an inefficient outcome?