Incentives versus transaction costs: a theory of procurement contracts

Inspired by facts from the private-sector construction industry, we develop a model that explains many stylized facts of procurement contracts. The bu yer in our model incurs a cost of providing a comprehensive design and is f aced with a tradeoff between providing incentives and reducing ex post tran saction costs due to costly renegotiation. We show that cost-phis contracts are preferred to fixed-price contracts when a project is more complex. Me briefly discuss how fixed-price or cost-plus contracts might be preferred t o other incentive contracts. Finally, our model provides some microfoundati ons for ideas from Transaction Cost Economics.