Simple menus of contracts in cost-based procurement and regulation

In an influential paper, Jean-Jacques Laffont and Jean Tirole (1986) formulated a principal– agent model of cost-based procurement and regulation and showed that the principal can implement the optimal mechanism by offering the agent a menu consisting of a continuum of linear contracts. Two related problems with applying this theory in practice have been that the economic logic and the underlying mathematics involved in calculating the optimal menu are quite complex, and the principal must be able to specify the agent’s entire disutility of effort function in order to calculate the optimal menu. As a result, the model has not been widely used in practice to either calculate actual incentive contracts or even to develop useful qualitative guidance about the nature of the optimal solution and how it is affected by various economic factors. The purpose of this paper is to show that dramatically simpler menus which are easy to understand and calculate and which have lower informational requirements, can, at least in some cases, capture a substantial share of the gains achievable by the fully optimal complex menu. In particular, this paper considers two-item menus where one item is a cost-reimbursement contract and the other item is a fixed-price contract. Such menus are called Fixed Price Cost Reimbursement (FPCR) menus. For the case where the agent’s utility is quadratic and the agent’s type is distributed uniformly, it is shown that the optimal FPCR menu always captures at least three-quarters of the gain that the optimal complex menu achieves (where the gain is measured relative to the result of using a cost-reimbursement contract). This paper’s research was originally motivated by a policy issue in defense procurement. In the United States, the Department of Defense (DOD) purchases almost all major weapons systems from sole-source contractors using contracting methods that essentially amount to using cost-reimbursement contracts. The best way to understand why DOD uses costreimbursement contracting methods is that they perform precisely the function identified in Laffont and Tirole’s principal–agent model; they guarantee, in a situation that amounts to a bilateral monopoly, that DOD and the firm can reach an agreement (i.e., they guarantee that the agent will always produce the good.) Of course the use of cost-reimbursement contracting methods