Optimal Procurement Contract with Cost Overruns

This paper studies the optimal procurement contract in the presence of potential cost overruns. The firm s delivery cost depends on its efficiency-type, which is private information. The delivery cost can take two values: planned or overrun. The lack of cost overruns is considered to be a noisy signal of the firm s effort to properly manage the project. The firm is protected by limited liability. Faced with adverse selection, then moral hazard, we show that the buyer offers a fully pooling incentive scheme to the firm. Moreover, the incentive compensation scheme can be implemented by a pair of fixed-price contracts..