Simple menus of cost‐based contracts with monotone optimal effort

Abstract

AbstractThis paper extends the fixed‐price cost‐reimbursement (FPCR) menu by allowing the agent's cost‐reducing optimal effort to be monotone 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 exert effort, 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 take into account the cost structure or, more exactly, the monotonicity of optimal effort in type.