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Incentives versus Transaction Costs: A Theory of Procurement Contracts


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  • Patrick Bajari
  • Steven Tadelis


November 2, 1999 Inspired by facts from the private sector construction industry, we develop a model that explains many of the stylized facts about 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 or when time-to-completion is more valuable. We also show when fixed-price or cost-plus contracts would be preferred to other incentive contracts, explaining the prevalence of these simple contracts. We then apply our model to the make-or-buy procurement decision and conclude that internal production dominates market procurement when the product is more complex, providing foundations for Transaction Cost Economics. (JEL D23, D82, L14, L22, L74)

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Paper provided by Stanford University, Department of Economics in its series Working Papers with number 99029.

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Date of creation: 02 Nov 1999
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Handle: RePEc:wop:stanec:99029

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