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Incomplete Contracting and Target-Cost Pricing

Listed author(s):
  • Dieter Bös
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    Target-cost pricing has been a widely applied formula in defence contracting. If this type of pricing arrangement is chosen, the seller's ex-post profit consists of a fixed payment plus some share of the cost overrun, that is the difference between an ex--ante agreed estimation of the production costs and the actual production costs. In an incomplete--contract setting, where relationship-- specific investments have to be made prior to the production stage, the cost-reimbursement properties of target-cost pricing work against a first best. However, since costs are verifiable, the ex-- ante contract allows to condition the initial contract on costs, that is, to stipulate a separate trade price for each cost observation, plus a special price for the no--trade case. (If costs are non--verifiable, it is only possible to fix one price for trade and one price for non--trade.) This increase in the number of instruments available to the agents works in favour of a first best. The paper shows that the positive properties of target-cost pricing outweigh the negative ones: it is possible to find prices which induce the agents to invest efficiently into relationship-specific investments, thus avoiding Williamson's hold-up problem. This result is particularly important because fixed-price contracts a la Hart-- Moore (1988) fail to achieve the first best if they are applied in the same environment in which target-cost prices succeed in attaining the first best. Since any contract, which implies full cost-reimbursement, also fails to achieve the first best, this paper shows that the first best requires just that middle-of-the-road approach which is offered by target-cost pricing.

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    Paper provided by University of Bonn, Germany in its series Discussion Paper Serie A with number 524.

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    Date of creation: Jun 1996
    Handle: RePEc:bon:bonsfa:524
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    Bonn Graduate School of Economics, University of Bonn, Adenauerallee 24 - 26, 53113 Bonn, Germany

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    1. Hart, Oliver D & Moore, John, 1988. "Incomplete Contracts and Renegotiation," Econometrica, Econometric Society, vol. 56(4), pages 755-785, July.
    2. Georg Noldeke & Klaus M. Schmidt, 1995. "Option Contracts and Renegotiation: A Solution to the Hold-Up Problem," RAND Journal of Economics, The RAND Corporation, vol. 26(2), pages 163-179, Summer.
    3. J. Michael Cummins, 1977. "Incentive Contracting for National Defense: A Problem of Optimal Risk Sharing," Bell Journal of Economics, The RAND Corporation, vol. 8(1), pages 168-185, Spring.
    4. Hartley, Keith, 1969. "Estimating Military Aircraft Production Outlays: The British Experience," Economic Journal, Royal Economic Society, vol. 79(316), pages 861-881, December.
    5. Aghion, Philippe & Dewatripont, Mathias & Rey, Patrick, 1994. "Renegotiation Design with Unverifiable Information," Econometrica, Econometric Society, vol. 62(2), pages 257-282, March.
    6. Ballard, Charles L & Shoven, John B & Whalley, John, 1985. "General Equilibrium Computations of the Marginal Welfare Costs of Taxes in the United States," American Economic Review, American Economic Association, vol. 75(1), pages 128-138, March.
    7. Tai-Yeong Chung, 1991. "Incomplete Contracts, Specific Investments, and Risk Sharing," Review of Economic Studies, Oxford University Press, vol. 58(5), pages 1031-1042.
    8. Bos, Dieter & Lulfesmann, Christoph, 1996. " The Hold-Up Problem in Government Contracting," Scandinavian Journal of Economics, Wiley Blackwell, vol. 98(1), pages 53-74, March.
    9. Sandler,Todd & Hartley,Keith, 1995. "The Economics of Defense," Cambridge Books, Cambridge University Press, number 9780521447287.
    10. Dieter Bös, 1996. "Privatization and Restructuring; An Incomplete-Contract Approach," IMF Working Papers 96/101, International Monetary Fund.
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