Innovations in Defense Acquisition: Asymmetric Information and Incentive Contract Design

Abstract

This report continues a research stream initiated in 2007 to apply mechanism design concepts to the DoD's acquisition transactions. Recognizing the central importance of private information and incentives, mechanism design reflects the decisions made by individuals and institutions based on the information they possess and the incentives they face. The designer chooses the mechanism (institutional structure) that promotes the desired outcome (decision or resource allocation). This research addresses asymmetric information in contract negotiations eliciting accurate information from a contractor to determine the most cost-effective combination of performance, schedule and cost. During the final contract negotiations, the contractor has the best information about the true cost to deliver a product or service with the desired quality and within the proposed schedule, but has an incentive to misrepresent this information to obtain more favorable contract terms. This research describes a truth-revealing contract structure that has been refined for this specific DoD application and develops a spreadsheet model to implement this structure. The model incorporates a budget constraint and signals when the proposed contract parameters might exceed the budget constraint. It adjusts the cost target range so that total costs satisfy the DoD's budget constraint while maintaining truthful revelation properties.