Assignment:
1.In the case of Walgreen's vs. Sara Creek Property, Walgreen's, a full service pharmacy, had signed a 30 year lease with Sara Creek for space in a mall. The lease included an exclusivity agreement - no other drug store was to be given space in the mall for the length of the lease. With 11 years still to go on the lease, Sara Creek announced its intention to break the agreement and rent space to Phar-mor, a discount pharmacy that emphasized low prices over service and shopping selection. Sara Creek offered to pay Walgreen's damages, which Sara Creek argued could be "readily estimated". Walgreen countered that its damages were higher than Sara Creek believed, would be difficult to calculate, and would include intangibles. They asked the court for an injunction against letting the space to Phar-mor until the lease expired; in other words, they asked for specific performance. The lower court granted the injunction.
Sara Creek appealed. On appeal they argued that the value of having Phar-mor in the mall exceeded the losses Walgreen's would suffer from increased competition, which is why they agreed to pay Walgreen's losses. Walgreen, argued Sara Creek, should have to prove that the Sara Creek damage offer was too low.
In answering the following questions, it will be necessary to make reference to the quantities WD and PM, defined below. It will also be useful to think about such things as the Coase theorem, transactions costs, and the costs associated with various remedies.
WD: Walgreen's own estimate of the true damages it would suffer if Phar-mor were permitted to operate in the mall.
PM: The amount Phar-mor is willing to pay for space in the mall.
So, for example, if I asked for a condition under which it would be socially optimal for Sara Creek to lease the space to Phar-mor, this could be expressed as PM>WD, that is, the value of the space to Phar-Mor (as expressed by their willingness to pay to lease the space) is greater than the true damages to Walgreen.
a. If, as Sara Creek argued, the value of having the Phar-mor exceeds the damages suffered by Walgreen's, (PM>WD) then does allowing the injunction to stand prevent the socially optimal outcome from being reached? Explain.
b. If the court decided to overturn the injunction, then it would have to determine the proper level of damages. Is Walgreen's likely to reveal WD to the court? Why or why not?
c. Suppose that the court does decide to overturn the injunction, and after hearing testimony from both sides, determines the appropriate damages to be CD. What will happen if CD>PM>WD? Is the socially optimal outcome possible after this decision? Explain. (What will each party do following this decision?)
d. What will happen if WD>PM>CD? Is the socially optimal outcome possible under these circumstances? Explain. (What will each party do following this decision?)
e. If the court's goal is promoting social efficiency in this particular case, what factors should it consider in deciding between allowing the injunction to stand and allowing Sara Creek the option of breaking the lease and paying court-determined damages?
2. Frequent power outages trouble the residents of Storm City. Located in the center of the storm belt, the city experiences periodic windstorms that down trees and power lines. The tables below give some data about the likelihood of power outages and the consequences. (For example, the "more inspections" row of the table indicates that if the Power company chooses to do tree trimming and more inspections, the probability of an outage will be .2, and the marginal reduction in the probability of an outage due to "more inspections" is .1). As you can see there are actions that the power company can take to reduce the probability of an outage, and actions that households can take to reduce the costs of the outage.
Additional
Action taken Actor probability marginal cost of
of outage additional action
none power company 0.4 $0
tree trimming power company 0.3 $150
more inspections power company 0.2 $250
better transformers power company 0.1 $350
Additional
Action taken Actor costs of marginal cost of
outage additional action
none households $5,000 $0
candles, flashlights households $4,000 $150
eliminate freezer households $3,000 $200
replace electric heat households $2,000 $300
back-up generators households $0 $1,000
As discussed in class, society would like to minimize the total cost of this tort situation, where total cost = (cost of power company actions) + (cost of household actions) + probability of outage*costs of outage)
a. Suppose that the Power company has no liability for damages due to power outages. What actions will be taken by each party? Compute the total costs of this situation.
b. Suppose, on the other hand, that the power company is strictly liable for all outage-related damages. What actions will be taken by each party? Compute the total costs of this situation. Is this an improvement over the situation in part a?
c. Suppose that there is a simple negligence rule that assigns liability to the power company only for failure to trim trees. What actions will be taken by each party?
Compute the total costs of this situation. Is this an improvement over the situation in parts a and b?
d. Propose a negligence rule that will bring about the efficient set of actions, that is, the set of actions by the power company and the households that minimizes the total cost of this tort situation.
3. Consider again the Power company discussed in question 1. Suppose that the state, after years with a common law rule of no liability for the power company for outage related losses, passed a statute giving full liability to power companies in the event of power failures, as in part c.
a. What does economic theory predict will happen to the price of electricity in Storm City? Explain.
b. What would happen to premiums on homeowners' insurance sold to residents of Storm City? (homeowners' insurance typically covers losses due to power failures).
Extra Credit:
Federal Law specifies that in some cases, consumers have three days (a cooling off period) to back out of a contract they have signed. This federal law is described at the following web site:
https://www.ftc.gov/bcp/edu/pubs/consumer/products/pro03.shtm
Note that it applies only to certain types of sales contracts.
a. In general, economists argue that contracts should be enforced if they were entered into voluntarily. The cooling off period law essentially allows people to break contracts under certain circumstances. Is there an efficiency justification for allowing this in the cases covered by the law? (Note the sort of transactions that the law covers).
b. Suppose someone proposed to broaden the cooling off period law to apply to all goods worth over $500, even if sold from regular stores or permanent locations. Offer an argument for or against this proposal on economic efficiency grounds (Think about the incentives would the proposal would create. Are they incentives for more efficient or less efficient behavior? Think about why stores voluntarily allow returns under some circumstances, and not others. Why do they do this? Would it be better if they always had to accept returns?)