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Ambiguity Aversion and Cost-Plus Procurement Contracts

Abstract

This paper presents a positive theory about the contractual form of procurement contracts under cost uncertainty. While the cost of manufacture is uncertain it can be controlled, to an extent depending on the effort exerted by the agent. The effort exerted by the agent is not contractible but causes disutility to the agent. Hence, the amount of effort exerted depends on the power of incentives built into the terms of reimbursement agreed to in the contract. The analysis in the paper explicitly models the possibility that the belief about the cost uncertainty is ambiguous, in the sense that belief is described by a set of probabilities, rather than by a single probability. This allows us to incorporate ambiguity aversion (behavior of the kind seen in Ellsberg`s "paradox") into the players` objective functions. The paper finds that, provided the agent is more averse to ambiguity than the principal, the more the ambiguity of belief the lower the power of the optimal incentive scheme. The fix-price contract is optimal if there is no ambiguity, but if the ambiguity is high enough a cost-plus contract is optimal; in between, a cost-share scheme is optimal. It is contended that the finding is particularly useful in explaining facts about the wide use of cost-plus and similar low powered contracts in research and development (R&D) procurement by the U.S. Department of Defense.Procurement contracts, Incentive contracts, Uncertainty aversion, Ellsberg`s paradox, Cost reimbursement contracts, Cost-plus contracts, Fixed price contracts

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