Academic journal article American Economist

Choosing the Sharing Rate for Incentive Contracts

Academic journal article American Economist

Choosing the Sharing Rate for Incentive Contracts

Article excerpt

1. Introduction

Contracts assign responsibilities and rewards to parties entering in contractual relationships. However, improperly (or incompletely) written contracts lead to well known adverse selection and/or moral hazard problems. The quest for optimal contracts continues given the huge monetary stakes involved and, in certain cases, the very existence of markets is dependent on how contracts are specified. Contracting has evolved from cost-plus and fixed-price contracts to incentive contracts. Under cost-plus contracts, a principal pays ail project costs plus a fee to the agent; the agent receives a fixed fee under fixed-price contracts. While the principal bears all risks of adverse outcomes in the cost-plus case, the agent bears all such risks under fixed fees. One example of the former is contracts the U.S. government has with various private firms to run research laboratories for a fixed payment while the government bears all the costs. Garbage collection, on the contrary, is contracted out to private firms for a fixed fee by certain local governments. Incentive contracts allow risks to be shared between the contracting parties. In an incentive contract the principal pays only a fraction of project costs. Hence, the agent has an incentive to hold costs down.

A number of defense procurement contracts are cost-plus. The study of how a government agency might minimize project costs through toe choice of appropriate contracts gains importance in the face of revelations of overcharging by contractors. Various studies have examined incentive contracts in relation to cost-plus and fixed-price contracts. For example, see Cummins (1977), Laffont and Tirole (1988), McCall (1970), Shavell (1979), and Weitzman (1980).

Given that incentive contracts are clearly superior to the other two contractual modes, the problem of initially selecting (identifying) the least cost agent still remains. In other words, the principal would like to enter into an incentive contract with the most efficient agent. Here a recent development where incentive contracts are auctioned proves useful. This interesting line of research involves the merger of auction and contracting theories by providing for mechanisms to auction incentive contracts.(1) Possible applications of incentive contracting include contracts for environmental cleanup and highway construction.

This paper studies the case where a principal aims to minimize the total payment to an agent by auctioning a simple linear contract. Instead of writing a procurement contract through negotiations, bidding enables the principal to write an incentive contract with the lowest bid agent. The agent's incentive to lower costs is preserved because the principal pays some fraction (called the sharing rate) of project costs.(2) We are able to interpret the marginal conditions as the bid-to-cost ratio in terms of cost-and bid elasticities with respect to the sharing rate. The bid-to-cost ratio shows the relationship of the winning bid to expected project costs. Simulations are performed to show the effect of changes in these elasticities on the bid-to-cost ratio. The comparative static effect of a change in the exogenous number of bidders on the sharing rate is also studied. Finally, potential applications of these results are discussed.

The structure of the rest of this paper includes the model in section 2. In this section we use a simple model of incentive contracting to study how a principal minimizes costs by auctioning an incentive contract. The final section contains the conclusions.

2. The Model

The objective of the principal is to design a contract to minimize the total payment to the agent (or contractor).(3) This is done by auctioning an incentive contract. We examine situations under which auctioning of contracts might be desirable.

Under the various bidding mechanisms widely used for highway construction and offshore drilling, the principal pays a fixed amount while the agent receives some fraction (or all) of the winning bid. …

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