Optimal Incentive Contracts in Project Management

Abstract

Motivated by the ever-growing complexity of projects and the consistent trend of outsourcing of individual tasks or components, we study the contract-design problem faced by a firm (or organization) for executing a project consisting of multiple tasks, each of which is performed by an individual contractor whose efforts (work-rates) are not observable. While the contractors incur costs continuously during the course of their tasks, the firm realizes its reward or revenue only when the entire project is (i.e., all tasks are) completed. The firm's contract-design decisions and the contractors' effort-level decisions are all governed by the goals of maximizing the respective party's expected discounted profit. We adopt the framework in Kwon et al. (2010a) and Chen et al. (2015), and derive optimal contracts for both parallel projects (tasks can be performed in parallel) and sequential projects (tasks have to be performed sequentially). The simplicity of the contracts we obtain suggests that there is potential for designing profit-maximizing contracts without paying a price in terms of contract complexity.

Keywords: Project Management, Contract Design, Dynamic Programming, Unobservable Effort

JEL Classification: D86, L24