Midterm Exam

This is a take home exam that will not count for your grade. I advise you to take it closed book, since that is how the final exam will be given. If you wish to hand it in I will grade it for you. Spend as long as you like on it, but keep track of how long it takes.

I. Your client was hit by a car while riding her bicycle. During her hospital stay she incurred $10,000 in medical expenses. Although it appears she has fully recovered, there is some chance of permanent damage. She has been advised, if her headaches continue, to return for further examination.

Just after leaving the hospital, she received an offer from the driver's insurance company for $100,000 to finally settle any claims she has arising from the accident.

If she sues and the case goes to trial, her trial costs will be $10,000. The probability that she will win is 90%. If she wins, the damages will be either high (probability 20%) or low (probability 80%).

High: She will receive $400,000 (permanent partial disability, etc.).

Low: She will receive $25,000.

Draw the decision tree for the problem as described. What should your client do?

She should accept the settlement offer, since $100,000 is more than $80,000.

How, if at all, would your answer change if you allow for the fact that your client is probably risk averse.

That would strengthen the conclusion, since it would lower the value of uncertain outcomes on the top branch of the diagram.

II. The situation is the same as in I, except that there are now two players--you and the insurance company. The insurance company starts by deciding how large a settlement to offer--$50,000, $100,000, or $150,000. You then decide whether to accept it. Use the idea of a subgame perfect equilibrium to figure out what offer the insurance company will make. Assume their trial costs are also $10,000.

First they make an offer, then you decide whether to accept it. Everything after that is chance. If they offer $100,000, you will accept, as we have already seen. If they offer $150,000 you will certainly accept. If they offer $50,000, you will not accept, unless your client is very risk averse--assume not.

If you reject their $50,000 offer, they on average pay out $90,000 to you and $10,000 to court costs, for a total of $100,000. If you accept their $100,000, they pay out $100,000. If you accept their $150,000 offer, they pay out $150,000.

If they are risk neutral, they are indifferent between the results of offering you $50,000 and $100,000. If they are at all risk averse, they prefer the latter.

III. Describe some situation that you as a lawyer might face with the structure of a prisoner's dilemma--a game where each party has a dominant strategy and where the result of following those strategies is an outcome that makes both of them worse off than they could be by doing something else. How might you try to avoid that outcome? You should not use an example discussed in class.

IV: Clark Community College (CCC), like many colleges and universities, has had a notoriously bad food service for years. (You do not want to know the details.) After hunger strikes, sit-ins, and food fights, the administration has finally decided that enough is enough. Time to contract out before it’s too late.

CCC has decided that it makes the most sense to use its existing cafeteria facility, which (aside from the food) is an attractive dining spot that is well located and fully equipped. The plan is to bring in an outside company to operate the facility.

You, a member of CCC’s legal department, are handling the negotiations with Gourmets and Gourmands (GAG), a well-known regional food service company. They have offered to contract with CCC on any of three bases:

1. They will supply meals, according to a menu specified in advance, on a flat-fee basis (e.g., students and staff would be charged $5 per hot lunch, $1.50 for a bagel and cream cheese).

2. They would agree to set prices on a cost-plus basis (covering labor, supplies, and an additional 20% to cover overhead and provide some profit). Students and staff would be charged the cost-plus price calculated by GAG.

3. They would simply provide whatever food they choose, at whatever prices they thought appropriate, and would pay CCC a fixed charge per month as rental for the facility. Students would be charged the price set by GAG.

Write a memo that does the following:

Explain the pros and cons of any two of the three contracts. Which seems better?

Briefly suggest modifications or alternatives that might address some of the problems you identify with either or both of the two contracts that you have analyzed.

1. Incentive to keep costs down, but also quality. But the incentive to cut quality is limited by the fact that the students and staff presumably don't have to eat there. Problem would be more serious if CCC were paying.

Could we define quality by contract? Hard. Perhaps measure by number of students who choose to buy. Could have an objective measure of waiting time in lines.

2. Less incentive to keep costs and quality down--but again, some because they only get the cost plus price on units that are bought. "Cost plus" limits the range of monopoly pricing--if they can't easily inflate apparent but not actual costs. But measuring costs may be hard--how to allocate central office costs?

3. They now charge the profit maximizing price. They have an incentive to keep costs down and quality up--the latter to keep customers, the former to maximize profits. Very much like an ordinary restaurant. But … not constrained by competition.

Might lease to multiple suppliers. Or provide dining area for brown bag, coin operated machines, … .

V. Numismatics Unlimited is a rare coin company.

A. How would each of the following events be represented as T diagrams?

1. The company buys 100 rare gold dubloons for $100 each

2. The company receives an order for ten of the dubloons from a customer, sends him the coins, and bills him for them at $150/each.

3. The company buys another 50 dubloons for $200 each.

4. A customer buys twenty dubloons at $250 each, paying cash.

The diagram assumes FIFO. With LIFO the amount would be $4000 instead of $2000.

5. A coin collector looks over the remaining dubloons and discovers that ten of them are fakes, worth only $10 each for their gold content.

Since accounting value of inventory is normally based on purchase price, I think we can ignore this--and I have in the diagram.

Alternatively, it could be treated like the recognition of a bad debt--inventory credited by $900 (FIFO) or $1900 (LIFO), balanced by an equal debit to cost, or perhaps an extra term debited on its own diagram, but eventually showing up as a negative term on the income statement and so a decrease in equity.

6. The coin collector tells his friends what he discovers; the reputation of the firm declines as a result.

No Accounting Change

B. How has the company's balance sheet changed as a result of these transactions?

1. Assets consist of $10,000 less in cash, $10,000 more in coins

2. Assets consist of $1000 less in coins, $1500 more in cash. Equity up by $500

3. Assets consist of $10,000 less in cash, $10,000 more in coins

4. Assets consist of $2,000 less in coins (FIFO) or $4,000 less (LIFO), $5000 more in cash. Equity increases by $3000 (FIFO) or $1000 (LIFO)

5. If recognized at this point, inventory (coins) decreases by $900 (FIFO) or $1900 (LIFO), equity down by $900 or $1900.

6. No effect on balance sheet at this point, although there might be later declines as a result.