Incomplete Contracting and Target-Cost Pricing
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.
|Date of creation:||Jun 1996|
|Date of revision:|
|Contact details of provider:|| Postal: |
Fax: +49 228 73 6884
Web page: http://www.bgse.uni-bonn.de
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- 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 128-38, March.
- Oliver Hart & John Moore, 1985.
"Incomplete Contracts and Renegotiation,"
367, Massachusetts Institute of Technology (MIT), Department of Economics.
- Aghion, Philippe & Dewatripont, Mathias & Rey, Patrick, 1994.
"Renegotiation Design with Unverifiable Information,"
12375014, Harvard University Department of Economics.
- Aghion, Philippe & Dewatripont, Mathias & Rey, Patrick, 1994. "Renegotiation Design with Unverifiable Information," Econometrica, Econometric Society, vol. 62(2), pages 257-82, March.
- Mathias Dewatripont & Philippe Aghion & Patrick Rey, 1994. "Renegotiation design with unverifiable information," ULB Institutional Repository 2013/9591, ULB -- Universite Libre de Bruxelles.
- Hartley, Keith, 1969. "Estimating Military Aircraft Production Outlays: The British Experience," Economic Journal, Royal Economic Society, vol. 79(316), pages 861-81, December.
- Nöldeke, Georg & Schmidt, Klaus M., 1995.
"Option contracts and renegotiation: A solution to the Hold-Up Problem,"
Munich Reprints in Economics
19329, University of Munich, Department of Economics.
- 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.
- Georg Nöldeke & Klaus M. Schmidt, 1992. "Option Contracts and Renegotiation - A Solution to the Hold-Up Problem," Discussion Paper Serie A 417, University of Bonn, Germany, revised Aug 1993.
- Dieter BÃ¶s, 1996. "Privatization and Restructuring; An Incomplete-Contract Approach," IMF Working Papers 96/101, International Monetary Fund.
- 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.
- 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.
- Chung, Tai-Yeong, 1991. "Incomplete Contracts, Specific Investments, and Risk Sharing," Review of Economic Studies, Wiley Blackwell, vol. 58(5), pages 1031-42, October.
When requesting a correction, please mention this item's handle: RePEc:bon:bonsfa:524. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (BGSE Office)
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.