Contracting for Complex Products

Abstract

The US Federal Government spends just under twenty percent of its budget buying everything from paper clips to complex weapons systems. Effective contracting promises win-win exchanges: governments gain efficiency and qualities not available through in-house production, and vendors win because the price is above their production costs. Markets are most likely to produce win-win outcomes when buyers and sellers can easily define and verify product cost, quality and quantities. We call these simple products. Markets for simple products tend to have large numbers of buyers and sellers who are well informed about each others offerings, can easily enter and exit the market, and can clearly define the terms of exchange. In such ideal circumstances, contracts are relatively complete in that there are few unanticipated circumstances in which the buyers and sellers roles are not clearly defined. If for some reason a buyer or seller fails to live up to her obligations, the transgression is quickly and easily recognized and a richly competitive market provides a replacement partner seeking similar terms. When markets fail, the win-win outcomes of contracting are replaced by lose-lose or win-lose outcomes where the winner's gains are greater than the loser's losses. One source of market failure is buyer and seller uncertainty about the product in the exchange, what we call complex products.[1] Unlike simple products, the cost, quality and quantity parameters of complex products can not be easily defined or verified, leaving buyers and sellers unable to clearly and completely define exchange terms (Bajari & Tadelis, 2001).[2] The risk is that the government is the only purchaser and once the contract is let, the vendor is the only viable supplier, leaving each with no easy exit from the contract, limited information about costs and quality, and engaging a partner relatively unconstrained by market pressures. The consequence is a collective action problem in which the buyer and seller have incentives to exploit contract ambiguities for their own gain at the other's expense, risking mutually disadvantageous outcomes