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Incentives versus Transaction Costs: A Theory of Procurement Contracts

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  • Patrick Bajari
  • Steven Tadelis

Abstract

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)

Suggested Citation

  • Patrick Bajari & Steven Tadelis, 1999. "Incentives versus Transaction Costs: A Theory of Procurement Contracts," Working Papers 99029, Stanford University, Department of Economics.
    • Handle: RePEc:wop:stanec:99029
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    JEL classification:

    • D23 - Microeconomics - - Production and Organizations - - - Organizational Behavior; Transaction Costs; Property Rights
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • L14 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Transactional Relationships; Contracts and Reputation
    • L22 - Industrial Organization - - Firm Objectives, Organization, and Behavior - - - Firm Organization and Market Structure
    • L74 - Industrial Organization - - Industry Studies: Primary Products and Construction - - - Construction

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