Incentives versus Transaction Costs: A Theory of Procurement Contracts

TLDR

The buyer in our model incurs a cost of providing a comprehensive design and faces a trade‑off between providing incentives and reducing ex post transaction costs due to costly renegotiation. The study develops a model, inspired by private‑sector construction, to explain stylized facts of procurement contracts and discusses when fixed‑price or cost‑plus contracts may be preferred to other incentive contracts. The authors construct a model, grounded in private‑sector construction data, to explain many stylized facts of procurement contracts. The model shows that cost‑plus contracts are preferred to fixed‑price contracts for more complex projects and provides micro‑foundations for Transaction Cost Economics ideas.

Abstract

Inspired by facts from the private sector construction industry, we develop a model that explains many stylized facts of procurement contracts. The buyer in our model incurs a cost of providing a comprehensive design, and is faced with a trade-off between providing incentives and reducing ex post transaction costs due to costly renegotiation. We show that cost plus contracts are preferred to fixed price contracts when a project is more complex. We briefly discuss how fixed-price or cost-plus contracts might be preferred to other incentive contracts. Finally, our model provides some micro-foundations for ideas from Transaction Cost Economics.