Government Procurement Contract Design with Unobservable Productivity and Moral Hazard

Abstract

This study investigates the optimal incentive structure for a government procurement contract in the field of defense. Optimality implies that the government achieves efficient and cost-effective procurement through incentives that encourage the contracting firm to reduce costs in the presence of both moral hazard and adverse selection. To investigate the optimal contract scheme when moral hazard and adverse selection occur simultaneously, we employ a hybrid model of moral hazard and adverse selection. Our analysis shows that a low--powered incentive is optimal when the firm's productivity is unobservable and that the incentive rate is lower in the hybrid case than in the pure moral hazard case. This is because the government must pay informational rent to the firm to ensure that the firm is honest. We also find that the optimal incentive rate increases as the degree of information asymmetry decrease.

Keywords: Government procurement; Cost-based pricing; Cost-plus-incentive-fee contract; Fixed-price contract

JEL Classification: M41, M48, D86