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The optimal length of contracts with application to outsourcing

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  • Matthew Ellman

Abstract

This paper resolves three empirical puzzles in outsourcing by formalizing the adaptation cost of long-term performance contracts. Side-trading with a new partner alongside a long- term contract (to exploit an adaptation-requiring investment) is usually less effective than switching to the new partner when the contract expires. So long-term contracts that prevent holdup of specific investments may induce holdup of adaptation investments. Contract length therefore trades of specific and adaptation investments. Length should increase with the importance and specificity of self-investments, and decrease with the importance of adaptation investments for which side-trading is ineffective. My general model also shows how optimal length falls with cross-investments and wasteful investments.

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Bibliographic Info

Paper provided by Department of Economics and Business, Universitat Pompeu Fabra in its series Economics Working Papers with number 965.

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Date of creation: Feb 2006
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Handle: RePEc:upf:upfgen:965

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Web page: http://www.econ.upf.edu/

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Keywords: Contract length; market forces; incomplete contracts; holdup;

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Citations

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Cited by:
  1. Elisabetta Iossa & David Martimort, 2008. "The Simple Micro-Economics of Public-Private Partnerships," The Centre for Market and Public Organisation 08/199, Department of Economics, University of Bristol, UK.
  2. López-Bayón, Susana & González-Díaz, Manuel, 2010. "Indefinite contract duration: Evidence from electronics subcontracting," International Review of Law and Economics, Elsevier, vol. 30(2), pages 145-159, June.
  3. Elisabetta Iossa & Patrick Rey, 2010. "Building Reputation for Contract Renewal: Implications for Performance Dynamics and Contract Duration," CEIS Research Paper 155, Tor Vergata University, CEIS, revised 28 May 2010.
  4. Elisabetta Iossa & David Martimort, 2009. "The Theory of Incentives Applied to the Transport Sector," CEDI Discussion Paper Series 09-04, Centre for Economic Development and Institutions(CEDI), Brunel University.
  5. Chen, Bin R. & Chiu, Y. Stephen, 2010. "Public-private partnerships: Task interdependence and contractibility," International Journal of Industrial Organization, Elsevier, vol. 28(6), pages 591-603, November.
  6. Bard Harstad, 2009. "The Dynamics of Climate Agreements," Discussion Papers 1474, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  7. Klênio de Souza Barbosa & Pierre C. Boyer, 2011. "Competition for Local Public Services with Learning-by-doing and Transferability," Working Papers 06-2011, Universidade de São Paulo, Faculdade de Economia, Administração e Contabilidade de Ribeirão Preto.
  8. Klenio Barbosa & Pierre C. Boyer, 2012. "Discrimination in Dynamic Procurement Design with Learning-by-doing," CESifo Working Paper Series 3947, CESifo Group Munich.
  9. Matthew Ellman, 2006. "Does privatising public service provision reduce accountability?," Economics Working Papers 997, Department of Economics and Business, Universitat Pompeu Fabra.

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