On the optimality of cost-based contracts in sole source procurement

Abstract

This paper focuses on the optimality of a purchaser using ex-post costs in compensating a supplier in the context of sole source procurement. Traditional agency work has shown that, under certain conditions, it may be optimal for an agent to be held responsible for uncontrollable outcomes. In this paper, limiting conditions are examined under which it would not be optimal for the purchasing firm to base the payment to the supplier on perfectly observable actual costs, even though the supplier has considerable control over these costs. It is shown that the relative severity of the moral hazard and adverse selection issues leads to the relative domination of the fixed price contract and the cost-plus contract. Also, the optimal linear procurement contract approaches a fixed price contract as the adverse selection problem decreases relative to the moral hazard problem and, conversely, the optimal contract approaches a cost-plus contract when the adverse selection problem increases relative to the moral hazard problem. An empirical implication of the results is that projects involving a low level of information asymmetry between the contracting parties would tend to have fixed price contracts as opposed to cost-plus contracts.