Firm X has promised to deliver an order of industrial parts to firm Y. However,

Question

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.

• 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.

• 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 non-delivery is set at $100,000 instead?

Explanation / Answer

Such contracts lead to inefficient actions and outcomes for the following reasons:-As the supplier of industrial parts usually receives advance payment from the client(here firm Y) and might choose to back off from their supply commitments because they do not have to effectively suffer a loss.Also, other client might be willing to offer a higher price for the same products. The supplier can get into a new contract will the other client and violate the contract signed with firm Y. only, in cases when a penalty has to be paid up for non-delivery, will a supplier be taking the contract seriously.From the client's point of view, there is always an uncertainty associated to the delivery of inputs which might lead to financial losses for the firm and non-completion of the products. If a penalty of $50,000 is imposed when firm X doesn't deliver, it will still not lead to effecient outcomes. The cost of fulfilling Firm Y's order is $50,000(minimum cost) and the penalty is also of the same amount. Firm X will be indifferent to fulfillment of order and paying up a penalty.However, when the penalty is fixed at $100,000, it is for sure that the penalty paid up will definitely be higher than the cost of producing the order and probably greater than the advance received for the order(if any).

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