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Ambiguity Aversion and Cost-Plus Procurement Contracts

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Sujoy Mukerji

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Abstract

This paper presents a positive theory about the contractual form of procurement contracts under cost uncertainty. While the cost of manufacture is uncertain it can be controlled, to an extent depending on the effort exerted by the agent. The effort exerted by the agent is not contractible but causes disutility to the agent. Hence, the amount of effort exerted depends on the power of incentives built into the terms of reimbursement agreed to in the contract. The analysis in the paper explicitly models the possibility that the belief about the cost uncertainty is ambiguous, in the sense that belief is described by a set of probabilities, rather than by a single probability. This allows us to incorporate ambiguity aversion (behavior of the kind seen in Ellsberg`s "paradox") into the players` objective functions. The paper finds that, provided the agent is more averse to ambiguity than the principal, the more the ambiguity of belief the lower the power of the optimal incentive scheme. The fix-price contract is optimal if there is no ambiguity, but if the ambiguity is high enough a cost-plus contract is optimal; in between, a cost-share scheme is optimal. It is contended that the finding is particularly useful in explaining facts about the wide use of cost-plus and similar low powered contracts in research and development (R&D) procurement by the U.S. Department of Defense.

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Paper provided by University of Oxford, Department of Economics in its series Economics Series Working Papers with number 171.

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Date of creation: 2003
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Handle: RePEc:oxf:wpaper:171

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Keywords: procurement contracts incentive contracts uncertainty aversion Ellsberg`s paradox cost reimbursement contracts cost-plus contracts fixed price contracts

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Find related papers by JEL classification:
D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General
D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information
D89 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Other

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  1. Gilboa, Itzhak & Schmeidler, David, 1989. "Maxmin expected utility with non-unique prior," Journal of Mathematical Economics, Elsevier, vol. 18(2), pages 141-153, April. [Downloadable!] (restricted)
  2. Sujoy Mukerji & Jean-Marc Tallon, 2003. "An overview of economic applications of David Schmeidler`s models of decision making under uncertainty," Economics Series Working Papers 165, University of Oxford, Department of Economics.
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  3. Ghirardato, Paolo & Maccheroni, Fabio & Marinacci, Massimo, 2002. "Ambiguity from the Differential Viewpoint," Working Papers 1130, California Institute of Technology, Division of the Humanities and Social Sciences. [Downloadable!]
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  4. Sujoy Mukerji & Jean-Marc Tallon, 2001. "Ambiguity Aversion and Incompleteness of Financial Markets," Post-Print halshs-00174539_v1, HAL. [Downloadable!]
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  5. Gilboa, Itzhak, 1987. "Expected utility with purely subjective non-additive probabilities," Journal of Mathematical Economics, Elsevier, vol. 16(1), pages 65-88, February. [Downloadable!] (restricted)
  6. Bajari, Patrick & Tadelis, Steven, 2001. "Incentives versus Transaction Costs: A Theory of Procurement Contracts," RAND Journal of Economics, The RAND Corporation, vol. 32(3), pages 387-407, Autumn.
  7. Schmeidler, David, 1989. "Subjective Probability and Expected Utility without Additivity," Econometrica, Econometric Society, vol. 57(3), pages 571-87, May. [Downloadable!] (restricted)
  8. Camerer, Colin & Weber, Martin, 1992. " Recent Developments in Modeling Preferences: Uncertainty and Ambiguity," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 325-70, October.
  9. Ghirardato, Paolo & Marinacci, Massimo, 2002. "Ambiguity Made Precise: A Comparative Foundation," Journal of Economic Theory, Elsevier, vol. 102(2), pages 251-289, February. [Downloadable!] (restricted)
  10. Marinacci, Massimo, 1999. "Limit Laws for Non-additive Probabilities and Their Frequentist Interpretation," Journal of Economic Theory, Elsevier, vol. 84(2), pages 145-195, February. [Downloadable!] (restricted)
  11. Epstein, Larry G & Zhang, Jiankang, 2001. "Subjective Probabilities on Subjectively Unambiguous Events," Econometrica, Econometric Society, vol. 69(2), pages 265-306, March.
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  12. Kirk Monteverde & David J. Teece, 1982. "Supplier Switching Costs and Vertical Integration in the Automobile Industry," Bell Journal of Economics, The RAND Corporation, vol. 13(1), pages 206-213, Spring. [Downloadable!] (restricted)
  13. Rogerson, William P, 1994. "Economic Incentives and the Defense Procurement Process," Journal of Economic Perspectives, American Economic Association, vol. 8(4), pages 65-90, Fall. [Downloadable!] (restricted)
  14. Mukerji, Sujoy, 1998. "Ambiguity Aversion and Incompleteness of Contractual Form," American Economic Review, American Economic Association, vol. 88(5), pages 1207-31, December. [Downloadable!] (restricted)
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