Negotiating a Deal

Donald and Andrew The Architect Andrew and the businessman Donald are negotiating a deal that Donald
would hire Andrew to design a clubhouse in Donald’s golf course in NY. This design would incur cost $10 to
Andrew.

1. (2) Andrew needs the profit to be at least $5 to join the deal. What is the minimum price p0 for the design
   with which Andrew would be interested to join the deal?
2. (2) At this price they reach a deal. After Andrew designs the clubhouse and the club- house is built, Donald
   comes to Andrew and says he would like to renegotiate the price for the design. Since the clubhouse is already
   built, the same design cannot be used in other places. Since a lawsuit would be costly, if they settle in a
   lawsuit, Andrew can only get a share 1 − w of the formerly agreed price p0, where w is a measure of the
   inefficiency of the legal system and 0 < w < 1. At what minimum price p1 for the design can now Donald just
   force Andrew to accept? Write p1 in terms of w.
3. (2) Based on your answer to the above question, understanding this potential renegoti- ation, will Andrew
   join the deal in the first place at the price p0? Why?
4. (1) The price difference p0 − p1 is a measure of the severity of the hold-up problem. Write it in terms of w.
5. (2) How does the inefficiency of the legal system affect the severity of the hold-up problem? Why?

Sample Solution