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Moral Hazard, Incentive Contracts, and Risk: Evidence from Procurement

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  • Gregory Lewis
  • Patrick Bajari

Abstract

Deadlines and late penalties are widely used to incentivize effort. Tighter deadlines and higher penalties induce higher effort, but increase the agent's risk. We model how these contract terms affect the work rate and time-to-completion in a procurement setting, characterizing the efficient contract design. Using new micro-level data on Minnesota highway construction contracts that includes day-by-day information on work plans, hours worked and delays, we find evidence of ex post moral hazard: contractors adjust their effort level during the course of the contract in response to unanticipated productivity shocks, in a way that is consistent with our theoretical predictions. We next build an econometric model that endogenizes the completion time as a function of the contract terms and the productivity shocks, and simulate how commuter welfare and contractor costs vary across different terms and shocks. Accounting for the traffic delays caused by construction, switching to a more efficient contract design would increase welfare by 22.5% of the contract value while increasing the standard deviation of contractor costs—a measure of risk—by less than 1% of the contract value.

Suggested Citation

  • Gregory Lewis & Patrick Bajari, 2014. "Moral Hazard, Incentive Contracts, and Risk: Evidence from Procurement," Review of Economic Studies, Oxford University Press, vol. 81(3), pages 1201-1228.
  • Handle: RePEc:oup:restud:v:81:y:2014:i:3:p:1201-1228
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    File URL: http://hdl.handle.net/10.1093/restud/rdu002
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    References listed on IDEAS

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    Cited by:

    1. Decio Coviello & Andrea Guglielmo & Giancarlo Spagnolo, 2015. "The Effect of Discretion on Procurement Performance," CEIS Research Paper 361, Tor Vergata University, CEIS, revised 17 Nov 2015.
    2. Decio Coviello & Luigi Moretti & Giancarlo Spagnolo & Paola Valbonesi, 2013. "Court Efficiency and Procurement Performance," "Marco Fanno" Working Papers 0164, Dipartimento di Scienze Economiche "Marco Fanno".
    3. Odolinski , Kristofer, 2016. "Contract design and performance of railway maintenance: effects of incentive intensity and performance incentive schemes," Working papers in Transport Economics 2016:20, CTS - Centre for Transport Studies Stockholm (KTH and VTI).
    4. Carroll, Gabriel & Meng, Delong, 2016. "Robust contracting with additive noise," Journal of Economic Theory, Elsevier, vol. 166(C), pages 586-604.
    5. Cesare Dosi & Michele Moretto, 2017. "Cost Uncertainty and Time Overruns in Public Procurement: a Scoring Auction for a Contract with Delay Penalties," Working Papers 2017.02, Fondazione Eni Enrico Mattei.

    More about this item

    JEL classification:

    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • H57 - Public Economics - - National Government Expenditures and Related Policies - - - Procurement
    • L92 - Industrial Organization - - Industry Studies: Transportation and Utilities - - - Railroads and Other Surface Transportation

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