Bidding for Contracts: A Principal-Agent Analysis

Abstract

This article models the process of bidding for government contracts in the presence of moral hazard. Several (possibly risk-averse) potential contractors (agents) submit sealed bids, on the basis of which the government (principal) selects one to perform a task. The optimal linear contract is derived. The bidding process induces the potential agents to reveal their relative expected costs. The optimal contract trades off giving the chosen agent an incentive to limit costs against stimulating bidding competition and sharing risks. The optimal contract is never cost-plus, may be fixed-price, but is usually an incentive contract. Some prescriptions for government contracting emerge.