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The Economic Sources of Beneficial Agreements 639

risks, this CE will be higherthan $50,000 (one-half the CE of 100 percent owner-

ship), though still lower than $70,000. In effect, each firm is more nearly risk

neutral when its risk is reduced proportionally. Let’s say each outfit’s CE is

$60,000. Then the total value of drilling as a partnership is 60,000 60,000 

$120,000. By selling a 50 percent profit share (for, say, $50,000), the original

option holder is better off (its total value increases from $100,000 to $110,000)

as is the purchaser (with an expected profit of 60,000 50,000 $10,000). Thus,

risk sharing has promoted a mutually beneficial transaction.^3

(^3) Since the two firms are identical, 50–50 risk sharing constitutes an optimal (i.e., value-maximizing)
contract.
CHECK
STATION 3
Suppose five identical, risk-averse wildcatters form a partnership to share equally the
profit or loss from the site discussed earlier. What is the effect on each outfit’s expected
profit and CE? What about the total value of the partnership (i.e., the sum of the indi-
vidual CEs)? As a thought experiment, extend the example to a 20-member syndicate.
What happens to the total value of the syndicate as the risk is split among more and
more firms?

Contingent Contracts

Agreements containing contingency clauses are a widespread response to the

presence of risk and uncertainty in economic transactions. Under a contingent

contract, the terms of the sale depend, in clearly defined ways, on the outcomes

of future events. Cost-plus contracts designed for high-risk procurements con-

stitute one broad class of contingent contracts. The widespread use of variable-

rate mortgages is another important example. Such contracts facilitate risk

sharing; the use of contingent pricing typically means that both sides’ returns

depend on the outcomes of uncertain economic variables. Contingent con-

tracts also can facilitate transactions when parties hold conflicting probability

assessments. The following example makes the point.

CONTINGENT PRICING IN AN ACQUISITION Firm A is negotiating to buy a

division of firm T. The difficulty is that the value of the division depends on

whether it wins the bidding for a major contract from the government. If it

wins, the division will be worth $20 million under current management and

$22 million if acquired by firm A. If it loses, it will be worth $10 million under

current management and $12 million if acquired by firm A. In either case, the

division is worth more to firm A than to firm T, due to synergies with firm A’s

other operations. Firm T judges a .7 probability that the division will win the

contract, but firm A judges this probability to be only .4. Is a mutually benefi-

cial agreement possible?

To answer this question, first consider a straight cash buyout. Firm T values

the division at (.7)(20) (.3)(10) $17 million. The price must be at least this

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