FPFE Support Class 2

cutting deals (the Coase Theorem)

Julian Winkler
Pareto Efficiency

 We need to be able to objectively compare outcomes. We do so using Pareto

efficiency: the outcome if Pareto efficient if no player can be made better off
without making at least one player worse off.
 Pareto efficiency does not necessarily imply that the ‘size of the pie’ should be
maximized, or that the outcome is ‘fair’.
 Will parties reach Pareto-efficient outcomes on their own? The Coase
Theorem suggests they do.
 For any initial allocation of rights, the players would achieve, through bargaining,
a Pareto efficient outcome, provided that the rights are well-defined and there are
no frictions (‘transaction costs’).
 Games

 We need a method to analyse what players

will do (through their ‘spontaneous’
interactions). We do so by formalizing the
interaction in a game.
 Rubinstein’s alternating offers dynamic
bargaining game is one way to formalize
bargaining.
 We studied sequential and simultaneous
games, and discovered that the structure
of the game can critically affect
outcomes.
A debtor, D, has secured debt b outstanding with a face-value of 70. He has some cash reserves, 100,
from previous operations (not depicted in the Figure below). If the project is continued, it will
generate additional cash of 100. If D defaults strategically (i.e. just in order to renegotiate the
debt), the creditor, C, obtains the right to liquidate the project assets, which would be worth 40.
Alternatively, C and D can renegotiating a deal whereby D “buys back” C’s liquidation right. In such
renegotiation, D makes a “take it or leave it offer” to C.

Complete the following graph inserting payoffs for C and D respectively in the brackets marked
(......,......).

In equilibrium, C expects that in case of renegotiation D’s offer will be……..and it is therefore in D’s
best interest to default / repay the debt up front.
In equilibrium, C expects that in case of renegotiation D’s offer will be…40…..and it is therefore in
D’s best interest to default / repay the debt up front.

70 130

40 160

100

Explanation:

During renegotiation, D will offer C minimum that C would accept,

which is 40. If offered less, C would liquidate the project and get 40,
and D is left with the initial cash (100). Expecting that C will accept an
offer of 40, it is optimal for D to default and get 200-40=160, rather
than repay debt upfront and get 200-70=130.
A debtor, D, can raise secured debt from a risk neutral creditor, C, to fund a project, described in the
graph below. With a probability of 50% the project is “liquid”. It generates an observable cash flow of
200. The creditor can readily enforce it by the threat of litigation. Otherwise, the project is in
distress. This means that although it still has the potential to generate the same amount of cash,
200, half of that amount 100, is delayed. In addition, both the early and the delayed cash flows are
not observable to a court of law. They cannot, therefore, be recovered by threat of litigation. The
only remedy that C has is to liquidate the project in case D defaults on the contracted amount. The
liquidation value is 50. Because of the problems in observability it is impossible to make the
payments contingent on the events of project distress or liquidity. However, before actual
liquidation, D may try to default strategically, in order to renegotiate the debt. He wants to buy back
the liquidation right for cash. D has no cash other than what he earns from the project.

Suppose that due to a “soft” bankruptcy law, D has all the bargaining power so that he can give C a
“take it or leave it offer”. Complete the graph below; D’s maximum borrowing capacity is ……………….
Explain your answer:
Suppose that due to a “soft” bankruptcy law, D has all the bargaining power so that he can give C a
“take it or leave it offer”. Complete the graph below; D’s maximum borrowing capacity is ……125.
Explain your answer: b 200-b

50 150

100

Explanation:

During renegotiation, D will offer C the minimum that C would accept,

which is 50. Therefore, if the obligation on debt is greater than 50, D
rationally defaults in distress. In initial period, C can extend credit of
at most 0.5 ∙ 50 + 0.5 ∙ 200 = 125 if D promises to repay 200 (which, of
course, he does not do in distress).
Consider a setting identical to the one in the previous question only that now, the bankruptcy law
was tighter, giving C all the bargaining power in renegotiations: it is C who can give D a “take it or
leave it offer”.

Complete the graph below; D’s maximum borrowing capacity is ……………….

Explain your answer:

Complete the graph below; D’s maximum borrowing capacity is …150….

Explain your answer:

b 200-b

100 100

100

Explanation:

During renegotiation, C will offer D the minimum that D would accept,

which is 100. Therefore, if the obligation on debt is greater than 100, D
rationally defaults in distress. In initial period, C can extend credit of
at most 0.5 ∙ 100 + 0.5 ∙ 200 = 150 if D promises to repay 200 (which, of
course, he does not do in distress).
An insolvent firm, F, is in default. F has senior and secured debt, b, of 70. The risk-neutral creditor,
C, could liquidate the firm for a value of L=20. F’s owner can withdraw his effort from the firm in
order to exercise an outside option, which has a value of P. If he exercises that option then the firm
generates total cash flow of y=0. If the owner does not walk away to exercise his outside option, then
the firm generates a cash flow of y=50. P is either 10 or 0. The owner knows the true value of P, but
C does not: C assigns a probability of 15% that P=10 and a probability of 85% that P=0. F is unable to
reveal, in a credible manner, the true value of P.

It is in the creditor’s best interest to write down the debt to……..; as a result, there is a ………%
probability that this firm, which is economically viable, will be discontinued.
It is in the creditor’s best interest to write down the debt to 50; as a result, there is a 15% probability
that this firm, which is economically viable, will be discontinued.

Explanation:

C could write down debt to 40, in which case the owner would stay
with certainty and pay back 40. However, if C writes down debt to 50,
there is 85% chance that owner will stay and pay back, which yields
bigger expected payoff of 85% ∙ 50 = 42.5. With probability 15% the
owner leaves and the firm generates 0.
Consider a company, F, with no debt and uncertain future cash flows. Notice that the company
cannot be in financial distress but might be in economic distress. F’s contract with its manager
guarantees a salary of w=10, as long as the firm operates (the manager’s outside option is zero). F
could be voluntarily wound up by its owners, in which case it will generate a cash flow of L=20. F’s
owners believe that F’s future cash flows of either y=50 or y=10 are equally likely (see figure below);
the manager already knows which cash flow has been realized.

The owners can induce the manager truthfully to reveal his information by offering him a one-off
payment of …… if he declares that y=10, (in which case the owners would liquidate the company and
fire the manager), plus a small / sizeable equity position in the company (if the manager is granted
an equity position, then he would share the liquidation value as well as any second period cash flow
net of his own salary). Such a “golden handshake” would increase / have no effect on / decrease the
value of the company to its owners.
 The owners can induce the manager truthfully to reveal his information by offering him a one-off
payment of 10 if he declares that y=10, (in which case the owners would liquidate the company and
fire the manager), plus a small / sizeable equity position in the company (if the manager is granted
an equity position, then he would share the liquidation value as well as any second period cash flow
net of his own salary). Such a “golden handshake” would increase / have no effect on / decrease the
value of the company to its owners.

Explanation:

Without the handshake, the manager prefers to hide

bad news, so he is not fired and receives the salary of
10. Offering him a payment of 10 (+ a very small
equity in the company) to reveal 𝑦 = 10 resolves the
problem. The value with handshake 0.5 ∙ (50 − 10) +
0.5 ∙ 20 − 10 = 25 is greater than without: 0.5 ∙
(50 − 10) + 0.5 ∙ 0 = 20.
Players P1 and P2 play an alternating-offers Rubinstein bargaining game; there are two rounds of
bargaining, which occurs at times t=1 and t=2. The players bargain over the division of a “pie” of size
one. At t=1, P1 makes an offer (x1,1-x1) to P2, where x1 is the size of P1’s slice of the pie and 1-x1 is
the size of P2’s slice. If P2 accepts, then the offer is implemented and the game terminates. If P2
rejects the offer, then he makes a counter offer (x2,1-x2) at t=2, where x2 is the size of P1’s slice of
the pie and 1- x2 is the size of P2’s slice. If P1 accepts, then the offer is implemented and the game
terminates. If P1 rejects the offer, then the pie is discarded, the game terminates and both players
receive nothing. Both players have the same subjective discount factor of β=0.65.

In a sub-game perfect equilibrium, the game terminates after …… rounds with P1 getting …… and P2
getting …….
In a sub-game perfect equilibrium, the game terminates after 1 rounds with P1 getting 0.35 and P2
getting 0.65.

Explanation:

In the second round, P2 would offer nothing to P1 (𝑥2 = 0, which P1 would

accept) and get the payoff of 𝛽(1 − 𝑥2 ) = 0.65. Anticipating this, P1 offers 0.65
to P2 in the first round, which P2 accepts, and the game ends. P1’s payoff is
𝑥1 = 0.35.
Consider a bargaining problem identical in all respects to the previous slide, except that the
subjective discount factor of P1 is greater than 0.65, while the subjective discount factor of P2 is still
equal to 0.65.

Relative to Question 3, the equilibrium size of P1’s slice would increase / remain the same at /
decrease to ……
Relative to Question 3, the equilibrium size of P1’s slice would increase / remain the same at /
decrease to 0.35.

Explanation:

P1’s discounts factor does not affect how much he has to offer P2 in order for
P2 to accept the offer. It is P2’s discount factor that matters, since he is the
one who decides whether to accept P1’s offer in round 1, or proceed to the
second round and make a counter-offer.
The left-hand side of the graph below described a debt-overhang situation: a creditor C may
liquidate the firm, F, for 20 or, instead, allow it to carry on. It will generate 50 if the owner stays
put, and zero otherwise. The owner has an outside option, I, of 10. The current face value of debt
exceeds 50. The creditor considers his options: either to liquidate the firm, or to give up the
liquidation option but write down, unilaterally, the face value of the debt. To help him make the
decision, graph the value of the second option to the creditor as the function of the new face value
of debt.

value of debt to creditor

y=50
I=10

C F

0
L=20
face value of debt
 value of debt to creditor

y=50
I=10
40
C F

0
L=20
40 face value of debt

Explanation:

If the new face value of debt is between 0 and 40, the creditor is paid back in
full, so we have a 45° line. If the debt is greater than 40, however, the owner
walks away, leaving the creditor with nothing.
Two players each holds a $50 deposit that can be withdrawn on demand at any time. The bank has
investments that will have a value of a $100 if held to maturity. If the investments are liquidated
prematurely, they lose 60% of their value. The depositors have no genuine need of the money before
maturity, yet at some point before maturity they have to make a simultaneous decision whether to
“run on the bank” by withdrawing their deposit early, or to “stay”, i.e. hold their deposits to
maturity. The run and stay strategies are denoted R and S, respectively, in the table below. If both
run on the bank, each has an equal chance of getting all of his money. It is well known that the game
has a “bad” (R,R) equilibrium. Analyse the game under the alternative set-up, whereby the game is
dynamic so that the R-S moves are made sequentially, with Player 1 moving first and Player 2 moving
second, after he has observed Player 1’s move. Once a player has made a move he cannot change it.
Draw a diagrammatical description of game’s extensive form (i.e., in the form of a “tree” rather in a
tabular form as above).

Player 2
R S
R (20,20) (40,0)
Player 1
S (0,40) (50,50)
 S (50,50)

P2
S R
(0,40)
P1
S (40,0)
R P2

R (20,20)

Explanation:

At the second stage, if P1 runs the bank, P2 rationally runs as well (20>0),
yielding (20,20) to both. If instead P1 stays, P2 also stays (50>40), yielding the
efficient outcome (50,50). Anticipating the choices of P2 (backward
induction), P1 rationally chooses to stay. Subgame perfection eliminates “bad”
equilibrium (R,R).