Optimal Contracts for Outsourcing of Repair and Restoration Services

Abstract:     
Outsourcing of equipment repair and restoration is commonly practiced by firms across many industries. The operational performance of the equipment is determined by joint decisions of both the firm and the service provider. Although some decisions are verifiable (and thus directly contractible), many decisions in such settings are unverifiable. This naturally creates a double-sided moral hazard environment in which each party has incentives to free ride on the other party’s effort. A performance-based contract allows the firm to align the incentives of the service provider but also exposes the service provider to stochastic earnings that, in turn, create disincentives to the provider’s optimal decision making. To capture these issues, we develop a novel principal–agent model by integrating elements of the machine repairman model and a stochastic financial distress model within the double-sided moral hazard framework. We apply our model to solve the firm’s problem of designing the optimal performance-based contract. We find that the firm can attain the first-best profit by restricting the search space to only two classes of performance-based contract structures: linear and tiered. We show that the linear contract structure has only limited capacity for attaining the first-best outcome, contingent on the exogenous characteristics of the vendor. In contrast, the tiered contract structure allows the client to attain the first-best outcome regardless of vendor characteristics. Our results provide normative insights on the role of contract structures in eliminating any loss due to double-sided moral hazard or the vendor’s financial concerns. The results reported here also provide theoretical support for the extensive use of tiered contracts in practice.

Number of Pages in PDF File: 46

Keywords: Double-sided Moral Hazard, Performance-Based Contracts, Financial Distress, Machine Repairman Model

working papers series