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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.

Suggested Citation

  • Matthew Ellman, 2006. "The optimal length of contracts with application to outsourcing," Economics Working Papers 965, Department of Economics and Business, Universitat Pompeu Fabra.
  • Handle: RePEc:upf:upfgen:965
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    File URL: https://econ-papers.upf.edu/papers/965.pdf
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. David Martimort & Flavio Menezes & Myrna Wooders & ELISABETTA IOSSA & DAVID MARTIMORT, 2015. "The Simple Microeconomics of Public-Private Partnerships," Journal of Public Economic Theory, Association for Public Economic Theory, vol. 17(1), pages 4-48, February.
    2. Bård Harstad, 2016. "The Dynamics Of Climate Agreements," Journal of the European Economic Association, European Economic Association, vol. 14(3), pages 719-752, June.
    3. Elisabetta Iossa & Patrick Rey, 2014. "Building Reputation For Contract Renewal: Implications For Performance Dynamics And Contract Duration," Journal of the European Economic Association, European Economic Association, vol. 12(3), pages 549-574, June.
    4. 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.
    5. Elisabetta Iossa & David Martimort, 2011. "The Theory of Incentives Applied to the Transport Sector," Chapters,in: A Handbook of Transport Economics, chapter 29 Edward Elgar Publishing.
    6. Klenio Barbosa & Pierre C. Boyer, 2012. "Discrimination in Dynamic Procurement Design with Learning-by-doing," CESifo Working Paper Series 3947, CESifo Group Munich.
    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. 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.
    9. Matthew Ellman, 2006. "Does privatising public service provision reduce accountability?," Economics Working Papers 997, Department of Economics and Business, Universitat Pompeu Fabra.

    More about this item

    Keywords

    Contract length; market forces; incomplete contracts; holdup;

    JEL classification:

    • D23 - Microeconomics - - Production and Organizations - - - Organizational Behavior; Transaction Costs; Property Rights

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