John is buying some wood from Michael at a price of $50. He needs to build warehouse to put them in. He has two options: (i) build a high quality warehouse at a cost of $100; or (ii) build a simple warehouse at a cost of $50. He will use the materials to build fancy wooden furniture which he will then sell. In the high quality warehouse the wood will definitely not be damaged and the furniture produced will be worth $500. In the simple warehouse some wood may be damaged and the expected sales will be only $300. John is concerned that Michael may not deliver the wood (with probability p) in which case John cannot produce any furniture.
a) If there is no rule that would hold Michael liable for any damages if he breaches the contract, which type of storage space should John build?
b) Suppose instead that Michael would be liable for perfect expectation damages if he fails to deliver the wood. What would these damages be and what type of storage space should John build? Is this efficient?
c) What remedy would produce an economically efficient outcome?