Monitoring, Moral Hazard, Asymmetric Information, and Risk Sharing in Procurement Contracting

Abstract

This article characterizes the optimal procurement contract for a monopsonistic purchaser who contracts with a risk-averse supplier with private information about his costs and who contributes an unobservable effort. The costs incurred by the supplier may be uncertain, and the purchaser has access to a monitor of costs that may be subject to noise that complicates risk sharing. The purchaser prefers to respond to the observability problem with afixed-price contract and to respond to the private information problem with a cost-plus contract. With uncertain costs and a perfect monitor the optimal contract relieves the supplier of some risk, and the purchaser prefers that the effort of the supplier be subsidized. With deterministic costs and a noisy monitor the optimal contract places risk on the supplier, and the purchaser may prefer that the effort of the supplier be taxed. * Procurement of goods and services is an important form of economic exchange that is often characterized by bargaining and contracting rather than by exchange in a competitive market. The procurement setting analyzed here corresponds to the case in which the purchaser is a monopsonist who contracts with a single supplier, as in the case of the Department of Defense contracting for the delivery of a military system. In such a setting a principalagent model may be a reasonable representation of the relationship between the purchaser and the supplier, and the economics of the procurement arrangement is then captured in the contract. When the item procured is standardized, the relevant information is likely to be common knowledge, and risk may be minimal. In such a case a fixed-price contract may satisfactorily resolve the purchaser's contracting problem. In contrast, the model considered here is intended to represent the procurement of a nonstandardized item about which information is incomplete, costs are uncertain, and observability of supplier costs by the purchaser is limited. Procurement thus is complicated by the conjunction of adverse-selection, risk-sharing, and moral-hazard problems.