Contract Efficiency in the Presence of Demand and Cost Uncertainty

Abstract

Standard formulations of procurement contract problems analyse the tension between providing performance incentives while allocating risk appropriately. The standard model examines this problem in the context of procuring a single indivisible good that is easily defined but is characterised by uncertainty in the cost of production. In many real-world contracts, however, the procurement environment looks rather different. In this article, we examine contract efficiency in a complex contractual environment for services characterized by cost uncertainty and an unknown level of service provision. Using data on water and sewerage network maintenance services contracts from two Melbourne water retailers, we compare the expenditure across fixed-price and cost-plus service contracts. The results suggest that the fixed-price contracts outperform the cost-plus contracts, thereby confirming the standard result that efficient contracts trade-off risk for incentives.

Keywords: Contract design, uncertainty, risk, outsourcing

JEL Classification: L24, D82