Breaches of contract by sellers
Now consider the same market again, but suppose that contractual agreements are not honoured by sellers. Goods are again assumed to be exchanged by means of a contractual arrangement whereby sellers and buyers agree on a price P - but now buyers pay this price first, and after receiving this payment, sellers deliver the good. However, suppose for goods that are sold, sellers do not deliver a fraction p of them. In other words, some sellers will breach their contractual obligations and refuse to deliver the good. Suppose that firms agree to supply
Q° goods at a price of P. Then the total quantity that will actually be supplied is:
and total revenue is:
The marginal cost of supplying goods that have been contracted for delivery does not change. Imposing a zero profit condition in this market means that total revenue must equal total cost:
which means that: or:
Buyers believe that they will receive Q° units, but actually only receive Q' < Q° units. The additional revenue is pocketed by sellers. In the absence of any other market adjustment, this would mean that sellers would earn positive economic profits. But these positive profits cannot persist in a competitive equilibrium, and so firms compete those profits away by bidding down the price below marginal cost.
Assuming that buyers do not correctly anticipate that contracts will not be honoured and do not adjust their behaviour in response to the possibility of a breach of contract, there will be a welfare loss as a result of firms breaching their obligations. This comes about because buyers believe that they will receive benefits from the goods that they have paid for, but do not in fact receive those benefits. At the price of P = (1 - p)c, buyers are willing to purchase up to the point where u'(Q) = P = (1 — p)c. They therefore believe that they will obtain benefits of u(Q°). However, buyers only actually obtain Q' = (1 - p)Q° units of the good, and so only actually obtain benefits of u(Q') = u [(1 - p)Q°].
Buyers therefore pay D for some units of the good that do not end up being delivered, and enjoy total benefits of A + B + C. On the other side of the market, sellers incur costs of B + C. In aggregate, there is a welfare loss of F which is the shaded triangle in Figure 8.2.2.
Figure 8.2.2 The welfare effects of breaches of contract by sellers