BE Assignment.docx - Q1 Big Bird Air is legally obligated to purchase 50 jet engine from ERUS at the end of two years at a price of $ 200000 per engine

BE Assignment.docx - Q1 Big Bird Air is legally obligated...

This preview shows page 1 - 2 out of 3 pages.

Q1.Big Bird Air is legally obligated to purchase 50 jet engine from ERUS at the end of two years at a price of $ 200000 per engine. Confident that it is protected from opportunism with this contract, Big Bird begins making aircraft bodies designed to fit ERUS’s engines. Due to unforeseen events inthe aerospace industry, in the second year of the contract ERUS is in the brink of bankruptcy. It tells Big Bird that unless it increase the engine price to $300000, it will go bankrupt.a. What is the first thing should the manager of Big Bird Air do?b. How could this problem have been avoided?c. Did the manager of Big Bird use the wrong method of acquiring inputs?Answers:a.Firstly, the manager of Big Bird Air should take into consideration all the risks of thepurchase.Big Bird is experiencing a hold-up problem because of an incomplete contract; the contract did not specify what would happen if ERUS went belly-up. ERUS claims it will go bankrupt if Big Bird does not pay a price of $300,000 for the engines, in which case Big Bird will lose its specialized investment in aircraft bodies. The manager should verify that ERUS is indeed on the brink of bankruptcy. If not, Big Bird can take ERUS tocourt if ERUS does not honor the contract price. If ERUS is on the verge of bankruptcy, the manager should determine how much it would cost to obtain engines from another supplier versus making them within the firm. Once the manager knows the cost of each alternative, Big Bird may wish to bargain withERUS over how much more it will pay for the engines. This could be risky, however; the lower the price negotiated, the greater the chance ERUS will go bankrupt. New clausesmust be put into the contract to protect Big Bird against ERUS's bankruptcy. The manager should especially guard against attempts by ERUS to reduce the quality of the engines in an attempt to save money. In any event, Big Bird should not spend more money drawing up a new contract and paying for ERUS's engines than it would cost to obtain them from the best alternative source.b. This problem could have been avoided, if Big Bird fixed the price of the contract or predicted the change in price of the inputs.This problem illustrates that when contracts are incomplete, unanticipated events can occur that lead to costly bargaining and opportunism. The problem could have been avoided had Big Bird written clauses into the contract that protected it against ERUS's going bankrupt. If this was not possible, it could have vertically integrated and produced its own engines.c. It is possible, that the manager of Big Bird used the wrong method of acquiring inputs.
Background image
Image of page 2

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture