Cost-based pricing in government procurements with unobservable cost-reducing actions and productivity

ABSTRACT The effective and efficient implementation of government procurement improves social welfare, however, governments and policymakers struggle to refine contract arrangements. To investigate the optimal contract scheme, we analyze a hybrid model of moral hazard and adverse selection. We show that the contract price is higher when the firm’s cost–reducing capacity is unobservable than when it is observable. Moreover, the effect of the unobservability of the firm’s cost–reducing capacity becomes more severe as the information asymmetry between the government and the firm increases. We contribute to the literature by clarifying how information asymmetry leads to higher contract prices.