Procurement Contracts: Fixed Price vs. Cost Plus
39 Pages Posted: 22 Mar 1999
Date Written: March 15, 1999
Economists have applied the methodology of information economics and contract theory (mechanism design) to problems in procurement and regulation. With the standard adverse selection and moral hazard components, the principal should offer a menu of incentive contracts from which the employed firm (agent) will select a contract that reveals its hidden information. In reality, such menus are not observed. Researchers in engineering management have also studied the costs and benefits of alternative contractual arrangements. In this literature, time to completion, project complexity, construction change orders, and risk management are the fundamental problems in the contracting environment. A central conclusion is that "cost-plus" contracts minimize total completion time, while "fixed-price" contracts minimize total project costs. We develop a parsimonious model that formalizes these results and shed new light on the procurement process.
JEL Classification: D23, L14, L22, L74
Suggested Citation: Suggested Citation