Rondo Co. contracts with Hondo Co. to purchase 10 high quality components for it
ID: 3176732 • Letter: R
Question
Rondo Co. contracts with Hondo Co. to purchase 10 high quality components for its closet organizer kits. The components for each kit cost $50 and they enable Rondo to make a variable profit equal to $100. For part a. the parties split the surplus. Hondo, however, can make a lower quality component for $20. Rondo would not learn of this breech until after the payment is made. After this deal they do not expect to do any more business together.
a. Explain the incentive problem in this contract.
b. Now suppose that there is a .9 chance that they will do more business. Also, if they do more business, there is another .9 chance that they will meet again for a similar transaction. This process continues indefinitely. Thus, we may assume that the monthly discount factor is 0.9. Explain how a trigger strategy could be used.
c. What is the maximum price that they could contract for such that Hondo will choose to make high quality products?
d. Suppose that Hondo promises to pay Rondo $50,000 in the event that low quality components are discovered. Will the courts enforce this promise? Should they? Why?
Explanation / Answer
Answer (a)The incentive issue could be that if Hondo does not make quality products for Rondo, then the Rondo brand will suffer in the market. So the problem can be rectified by testing the products before payment.
(b) A TRIGGER STRATEGY could be applied in repeated prisoners dilemma in which there are 0.9 chance that they will do business as a response there is another 0.9 chance they will meet again for a similar transaction. Trigger strategy provides a discounted factor which is 0.9.
(C) The Rondo company had gave a price in which the hondo company could produce quality product.Therefore , the rondo company should give $50 for the component so they may produce high quality products.
(D) yes, the court will enforced the promise because the rondo company has made a contract with hondo company to produce high quality products. Since the company is paying a high value to get products, and if they find a breach in the contract, which has a clause that Hondo is payable for making low quality products, then the courts can enfore the same.
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