Contracting with Private Knowledge of Production Capacity

We analyze the design of procurement contracts when the supplier is privately informed about both his innate production capacity ( K ) and his innate unit cost of production. We identify conditions under which the supplier will strategically employ an inefficient production technology to expand output above K . We also show that when the buyer employs the simple fixed‐price cost‐reimbursement (FPCR) contracts in the setting examined by Rogerson (2003), the supplier has no incentive to exaggerate K . Furthermore, the buyer can secure with FPCR contracts at least 75% of the surplus she secures with fully optimal contracts.