Always Round Tire hires Plain Truth Advertising to write copy for its newspaper advertisements. Always Round has a demand for advertising of MB = 400 ?2S where S is the number of hours that Plain Truth works. If Plain Truth has a fixed supply cost given by MC = $150 per hour, what are the number of hours that Always Round purchases from Plain Truth? Now, if the copy writers are slackers and only deliver 100 hours of work each week, and if the each company must spend $1,250 in monitoring and bonding costs, what is the surplus and residual loss in this environment?
What will be an ideal response?
The number of hours that Always Round purchase from Plain Truth can be obtained by equating MB and MC. So400 ? 2S = $150 or S = 125 hours. If S=100 because of shirking by slackers, then the value created for Always Round Tire is
less the monitoring and bonding costs. The original surplus of $15,625 is reduced by $5,625 because lower numbers of hours are worked. This reduction in surplus of $5,625 is the residual loss. In addition, the company pays an additional $1,250 as bonding and monitoring costs for a total of $2,500. So a total of $5,625+$2,500 = $8,125 in surplus is lost because of the agency problems in contracting.
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