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Simple Menus of Contracts in Cost-Based Procurement and Regulation

Simple Menus of Contracts in Cost-Based Procurement and Regulation By WILLIAM P. ROGERSON* 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.1 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 http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png American Economic Review American Economic Association

Simple Menus of Contracts in Cost-Based Procurement and Regulation

American Economic Review , Volume 93 (3) – Jun 1, 2003

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References (21)

Publisher
American Economic Association
Copyright
Copyright © 2003 by the American Economic Association
Subject
Shorter Papers
ISSN
0002-8282
DOI
10.1257/000282803322157160
Publisher site
See Article on Publisher Site

Abstract

By WILLIAM P. ROGERSON* 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.1 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

Journal

American Economic ReviewAmerican Economic Association

Published: Jun 1, 2003

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