Simple menus of cost‐based contracts with monotone optimal effort

• Date: 01 October 2018
• Published date: 01 October 2018
• DOI: http://doi.org/10.1111/jpet.12302

A

742 © 2018 Wiley Periodicals, Inc. wileyonlinelibrary.com/journal/jpet Journal of Public Economic Theory. 2018;20:742–756.

Received:30 March 2017 Accepted:29 March 2018

DOI:10.1111/jpet.12302

ARTICLE

Simple menus of cost-based contracts with

monotone optimal effort

Yonghong An1DaiqiangZhang2

1TexasA&M University

2Universityat Albany

YonghongAn, Department of Economics, Texas

A&MUniversity, College Station, TX 77843, USA

(y.an@tamu.edu).

DaiqiangZhang, Department of Economics,

Universityat Albany, SUNY,Albany, NY 12222,

USA(dzhang6@albany.edu).

Thispaper extends the fixed-price cost-reimbursement (FPCR) menu

by allowing the agent's cost-reducing optimal effort to be mono-

tone in the agent's cost type. We show that the performance of the

optimal FPCR menu relies crucially on the monotonicity of optimal

effort. In particular, in an optimal FPCR menu, if the optimal effort

is increasing in type and only a portion of cost types are induced to

exerteffort, the performance of the optimal FPCR menu can be very

poor relative to the fully optimal contract.Our results suggest that in

designing an optimal FPCR menu it is important for the principal to

takeinto account the cost structure or, more exactly, the monotonic-

ity of optimal effort in type.

1INTRODUCTION

Because procurement by federal, state, and local government accounts for at least 10% of gross domestic product in

theUnited States (Bajari & Tadelis, 2001), public procurement of goods and services has attracted much attention in the

economicsliterature. The modern economic theories of procurement use mechanism design to model the procurement

problem as one of ex ante asymmetric information coupled with moral hazard. Basically,the agent has private informa-

tion about type of production cost that is unknown to the principal, and the principal screens the agent by offering a

menu of contracts from which the agent selects a particular contract,thus (partially) revealing his private information.

In practice, most contracts are variants of either fixed-price(FP) contracts for which the payment to the agent is an FP

regardless of the agent's realized cost or cost-reimbursement (CR) contractsfor which the agent is reimbursed exactly

the realized cost. Prominent examples include the Indian customized software industry (Banerjee & Duflo, 2000), the

U.S.Air Force engine procurement (Bajari & Tadelis,2001), and the French transport industry (Gagnepain, Ivaldi, & Mar-

timort, 2013). One fundamental difference between FP contractsand CR contracts lies in the fact that FP contracts are

high-incentive in the sense that under FP contracts the agent has incentive to makecost-reducing investment (effort)

to reduce its production cost, whereas under CR contracts the agent has little incentive to exertcost-reducing effort.1

Motivated by the practical prevalence, the seminal paper of Rogerson (2003) demonstrates that, when the agent's

cost type is uniformly distributed, a simple menu of contracts consisting of FP contracts and CR contracts captures

at least three-fourths of the surplus that a fully optimal contract achieves, where the fully optimal contract is pro-

posed by Laffont and Tirole (1986) to analyze the principal–agent problem of procurement and regulation, and can be

1Thecost-reducing investment represented by the cost-reducing effort is typically used in procurement contracts (Ma, 2003).

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