Contracting in the Shadow of the Future

Abstract

Contract design involves control mechanisms that trade off the provision of ex ante incentives to reduce losses from moral hazard, while avoiding costs of ex post adaptations. We examine how this tradeoff influences the form of the contract, namely cost-plus and fixed-price. We investigate whether two control mechanisms, i.e., the possibility of a future horizon, and bilateral reputation capital can mitigate the risk of cost-inefficiency in cost-plus contracts and adaptation costs in fixed-price contracts. We first develop an analytical model that shows that the attractiveness of a cost-plus contract is increasing in (a) the complexity of the task, (b) vendor rent seeking potential, (c) contracting parties’ potential for future business, and (d) vendor reputation for cost containment. On the other hand, vendor reputation for fair bargaining increases the attractiveness of a fixed-price contract. We test the predictions of the analytical model using data on procurement contracts collected from the SEC material contracts database, supplemented with hand collected data from trade and industry publications. Results using recursive, simultaneous, bivariate probit estimations with endogeneity corrections support our predictions.

Keywords: Information technology outsourcing, fixed price contract, cost plus contract, incentives, hold up, renegotiation, relational contract, procurement contracts, self-enforcing, reputation capital

JEL Classification: D2, D86, L24, M15