Question

AppleCo and BananaCo enter into a supply contract for hoodies. BananaCo's employees are unionized, and if a strike occurs, it will cost BananaCo $10,000 in lost profit, and will cost AppleCo $20,000. Ex Ante, allocating the risk of a strike costs $100, but once the strike occurs it will cost $2,000 to allocate the loss.

(a) There is a 5% probability of the strike occurring. Should the parties fill the gap or leave a gap in the contract with respect to strikes?

(b) Does your answer change if the probability of strike increases to 10%?

(c) Assuming the same 10% probability, does your answer change if the ex ante cost to allocate the loss decreases to $800?

Answer 1

a.

expected cost if they dont allocate risk of strike

E(cost) = P(strike)*(cost of strike) = 5% * 2000 dollars

E(cost) = 100 dollars

which is equal to cost of allocating risk so, both options are equivalent.

b.

if P(strike) = 10%

E(cost) = P(strike)*(cost of strike) = 10% * 2000 dollars

E(cost) = 200 dollars

200$ > 100$

E(cost) > cost of allocation of risk

therefore it is better to allocate the risk initially which costs only 100 dollars

c.

E(cost) = P(strike)*(cost of strike) = 10% * 800 dollars

E(cost) = 80 dollars

80 dollars < 100 dollars

here it is suggested to not allocate risk as expected cost of allocating risk is less

P.S. (please upvote if you find the answer satisfactory)