COST OBSERVABILITY AND RENEGOTIATION

A project requires an initial specific investment. The total cost of t he project depends on the probability that the supplier will experienc e a delay in the production schedule. This probability is the supplier 's private information. The buyer would like to hire a supplier with a low probability of delay. However, it can offer a screening contract only by committing to terminate the project if the supplier is not abl e to complete it within the original budget limits. We show that cost observability may prevent the buyer from terminating a cost overrun pr oject and this, in turn, prevents screening out 'bad' suppliers. Thus, we provide an example in which superior monitoring ability represents a disadvantage for the buyer. This finding contrasts with the common argument that better monitoring represents an advantage of integrated organizations.