SIEPR Policy
paper No. 99-25
Incentive versus Transaction Costs:
A Theory of Procurement Contracts
Partick Bajari and Steven Tadelis
March 2000
Inspired by facts from the private sector construction industry, we
develop a model that explains many of the stylized facts about
procurement contracts. The buyer in our model incurs a cost of providing
a comprehensive design, and is faced with a trade-off between providing
incentives and reducing ex post transaction costs due to costly
renegotiation. We show that cost plus contracts are preferred to fixed
price contracts when a project is more complex. We also show when fixed-price or
cost-plus contracts would be preferred to other incentive contracts,
explaining the prevalence of these simple contracts. We then apply our
model to the make-or-buy procurement decision and conclude that internal
production dominates market procurement when the product is more
complex, providing some micro-foundations for Transaction Cost Economics. (JEL D23,
D82, L14, L22, L74)