judges its CE value for going to court at $800,000 (including court costs), and the
large firm sets its CE at $1.1 million. Now there is a $300,000-wide zone of
agreement in the settlement negotiations. The presence of risk aversion makes
a certainout-of-court settlement more attractive than a risky outcome in court
(even though each side is optimistic about the outcome at trial).
As a general principle, transactions should be designed so that risks are
assumed by the party best able to bear them. Consider the wildcatter in
Chapter 12 who holds an option to drill for oil on a geological site. Suppose the
wildcatter estimates the expected profit of the site to be $140,000 but, being risk
averse, assesses the CE value of the site to be considerably less than this—say,
$100,000. Should the wildcatter explore the site or sell the option to a giant
exploration company that drills scores of wells in all parts of the world? Suppose
the large drilling company is risk neutral. If its geologists agree with the wild-
catter’s probabilistic assessments, the company’s value for the site is $140,000.
Consequently, the option can be sold at a mutually beneficial price between
$100,000 and $140,000. The option should be transferred to the risk-neutral
party because that party values the site more highly.
A classic case of a transaction designed for optimal risk bearing is the cost-
plus contract used in high-risk procurements. The risks concerning perform-
ance, cost, and timetable of delivery in defense procurement—for instance, in
the development of a new weapons system or aircraft—are enormous. As a
result, the usual fixed-price contract, in which the defense contractor is paid a
fixed price and bears all production risk, is impractical (that is, the firm would
set an extremely high fixed price—add a substantial risk premium—to com-
pensate for possible cost overruns). Given its vast financial wealth, the federal
government arguably can be characterized as risk neutral. The government,
rather than the firm, should bear the contract risk. Under a cost-plus contract,
the government reimburses the firm for all allowable costs and pays it a fixed
profit amount in addition. The large variability in cost is borne by the govern-
ment buyer, whereas the contractor’s profit is guaranteed. The government
benefits by paying the firm a much lower profit fee than would be required if
the firm were the risk bearer.^2
When both parties are risk averse, the optimal response to uncertainty is risk
sharing. Returning to the oil example, suppose a second drilling firm is identi-
cal to the first; that is, it is equally risk averse and holds the same probability
assessments. Then the site has a CE value of $100,000 to either party. Because
there is no difference in value, there is no possibility of mutual benefit from an
outright sale. But consider what happens if the two companies form a partner-
ship to share equally (i.e., 50-50) all profits and losses from drilling. The expected
value of each side’s 50 percent profit share is, of course, $70,000. What is each
side’s CE for its share? Because each outfit now is exposed to considerably smaller638 Chapter 15 Bargaining and Negotiation(^2) One disadvantage of the cost-plus contract is that it offers the firm very little incentive to keep
costs down.
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