A structural analysis of simple contracts

Abstract

This paper provides an econometric framework for analyzing two-period simple contracts where an agent chooses between a fixed-price option and a cost-reimbursement option provided by a principal in each contracting period. First, we propose a consistent procedure for testing the null hypothesis of a corresponding cost function being linear, which is widely assumed for tractability in the literature. Motivated by the rejection of such a null based on our empirical data, next we establish nonparametric identification, without restricting the cost function to be linear, for all model primitives conditioned on the agent exerting nonzero effort. These primitives include agent’s cost and disutility functions, distribution of agent efficiency type, and parameters that characterize agent’s bargaining power and intertemporal preference. Moreover, we propose a consistent procedure to implement the identification results for estimation. In our empirical study, we find strong evidence against linearity of the cost function. The importance of this empirical finding is further evidenced by a welfare analysis, which shows the welfare assessment to be sensitive to the specification of cost function.