Monitoring, Moral Hazard, Asymmetric Information, and Risk Sharing in Procurement Contracting

This article characterizes the optimal procurement contract for a monopsonistic purchaser who contracts with a risk-averse supplier with private information about his costs and who contributes an unobservable effort. The costs incurred by the supplier may be uncertain, and the purchaser has access to a monitor of costs that may be subject to noise that complicates risk sharing. The purchaser prefers to respond to the observability problem with a fixed-price contract and to respond to the private information problem with a cost-plus contract. With uncertain costs and a perfect monitor the optimal contract relieves the supplier of some risk, and the purchaser prefers that the effort of the supplier be subsidized. With deterministic costs and a noisy monitor the optimal contract places risk on the supplier, and the purchaser may prefer that the effort of the supplier be taxed.