Reference no: EM13921503

Postcontractual Information Problems and Agency Costs

a. The potential gains from trade of $100,000 equal the difference between Sue's reservation price for the house and John's cost of building the house: $400,000 - $300,000 = $100,000. These gains from trade are lost when Sue doesn't transact because of the incentive problem. Therefore, the total agency costs are $100,000. There are no out-of- pocket expenses. The $100,000 is a residual loss.

b. The total gains from trade are $65,000: $385,000 (Sue's valuation) - $20,000 (for the engineer) - $300,000 (John's costs) = $65,000. The total gains from trade of $65,000 are split as follows. Sue gets $15,000: $385,000 (her value for the house) - $20,000 (the cost of the engineer) - $350,000 (price of the house) = $15,000; John gets $50,000: $350,000 - $300,000 = $50,000. The total agency costs of $35,000 equal the difference between the potential gains from trade with zero contracting costs and the ac- tual gains from trade given costly contracting: $100,000 (see part a) - $65,000 = $35,000. These costs are divided into out-of-pocket costs and the residual loss. The out- of-pocket costs are $20,000 for the engineer. The residual loss is the remaining $15,000: $35,000 (total agency costs) - $20,000 (out-of-pocket costs) = $15,000. This residual loss reflects the fact that due to the agency problem Sue gets a house that she values at $385,000 instead of $400,000.

c. It would not be in Sue and John's interest to hire another engineer. Hiring the additional engineer costs $20,000, while elimination of the remaining residual loss is worth only $15,000. Thus, the gains from trade would fall by $5,000 if they hired the extra engi- neer. [The gains would equal: $400,000 (Sue's value) - $300,000 (John's costs) - $40,000 (cost of the engineers) = $60,000, which is $5,000 lower than when only one engineer is hired.]

d. Paying for the engineer is a value-increasing expenditure that reduces total agency costs and increases the gains from trade. It is in the joint interests of John and Sue to hire the engineer since it increases their gains from trade. It is not important who writes the check to cover this expense. How the gains from trade are split is ultimately determined by the transaction price. For example, the same split would occur if John wrote the $20,000 check for the engineer, and Sue paid $370,000 for the house. In some transactions, the gains from trade can depend on who writes the check, for example if one party can deduct the expense for tax purposes, while the other cannot.