Question

ISK Shaing 5. Consider a farmer who must sale an extensive pasture of 100 acres (the "Owner"). The pasture is currently covered by cedars and it is impossible to be sure of the productivity. The soil of the pasture is likely poor quality and can only support 10 cows, making it worth $50,000. But there is a 20 percent chance that it is high quality, meaning it can support 40 cows with a value of $200,000 a. After the pasture is purchased the Buyer can determine the productivity of the soil by clearing cedars, which he must do to use it in any event. . At what price will the owner sell the land? ii. Describe the returns to the owner and the buyer under each state of nature, and the expected returns. Also describe the expected returns to society. HINT: USE A TABLE il Should Courts enforce the contract if it turns out the land is high productivity? Suppose that there is a technology available to the Buyer for $25000 which can determine the productivity of the soil before buying. . At what price will the owner sell the land? ii. Describe the returns to the owner and the buyer under each state of nature, and the expected returns. Also describe the expected returns to society. HINT: b. USE A TABLE ili Should Courts enforce the contract if it turns out the land is high productivity? Now suppose that if the buyer discovers the value of the land by soil testing, he can build greenhouses for growing organic vegetables, making the land worth $300,000 i. How does this affect the expected returns to society? . Should Courts enforce the contract if it turns out the land is high productivity? c.

Answer 1

a.

i.

Value of low soil productivity= $50000

Chance of low soil productivity= 80%

Value of high soil productivity= $200000

Chance of high soil productivity= 20%

Soil value= 0.8* 50000 + 0.2* 200000= 80000

Soil value should be sold at $80000.

ii.

Return of seller in low productivity soil condition= (80000-50000)/50000= 60 percent

return of seller in high productivity soil condition= (80000-200000)/200000= -60 percent

Then estimated return for seller= 0.8* 60 percent + 0.2*(-60 percent)= 36 percent

similarly for buyer

return in low productivity= (50000-80000)/80000 = -37.5 percent

return in high productivity = (200000 - 80000) / 80000 = 150 percent

expected return = 0.8*(-37.5%) + 0.2* (150%) = percent

iii.

A contract should not be enforced by the court after the soil is found to be highly productive.

b. Since selller doesn't have such an instrument to enable it to determine what kind of soil there is. He should therefore buy soil at $80,000 only. If he considers it to be low productivity, he must purchase soil at $80,000 for the r. So he will lose only $25,000 as he won't purchase a low productivity floor.