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World Trade Organization - page 27 / 35





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Now consider the relationship between the GPA and issues of procurement contract design and implementation in situations of asymmetric information, shifting the focus from the procurer as agent to the procurer as principal.  The large and growing literature on procurement mechanisms has focused on the problems of both moral hazard and adverse selection (see Laffont and Tirole, 1993).  The former can arise when the procurer cannot observe endogenous variables such as cost reducing effort by the firm which has been awarded a contract based on cost-reimbursement.  The latter arise when the firm has more information than the procurer about some exogenous variables such as the firm's technological possibilities.

Procurement contracts are typically of three types:  fixed price contracts, incentive contracts and cost-plus contracts.  In fixed price contracts, the government does not reimburse any of the costs and only pays a fixed fee.  Such contracts make the firm the residual claimant for any cost savings.  In the cost-plus contract, the firm does not bear any of its costs.  These are reimbursed by the government who also provides an additional fixed fee.  In between these two polar cases are various incentive contracts in which the firm bears a part of its costs and also receives an additional fixed fee.30  

The procurer's problem is to devise a contract which achieves the most desirable balance between two conflicting goals:  to promote cost reduction and to extract the firm's rent.  A fixed price contract induces the right amount of effort because it makes the firm residual claimant for its cost savings.  Since any cost savings translate into increased profits for a firm, it has the socially optimal incentive to reduce costs.  In contrast, a cost-plus contract offers no incentive for cost reduction, since the firm does not appropriate any of its cost savings.  With regard to the goal of rent extraction, the ranking of the two types of contracts is reversed.  The fixed price contract enables the firm to gain from any exogenous cost reduction.  In contrast, the cost plus contract enables the government to extract maximum rent since the benefits of any exogenous cost reduction are appropriated by the government.  Optimal contracts are usually incentive contracts trading-off effort inducement, which calls

    (Scherer (1964) found that in 1960, 40.9 per cent of U.S. military procurement dollars involved cost plus contracts, 13.6 per cent incentive contracts, 31.4 per cent fixed-price contracts, and the rest were hybrid contracts.  He also found that cost-plus contracts were more employed for high technology than for standard equipment.  More recent empirical investigations of procurement contract structures, found, for instance, in Vistnes (1994) and Crocker and Reynolds (1993), confirm the use of a variety of contract types.


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