Contracting with Private Knowledge of Production Capacity

Leon Yang Chu and David Sappington

Journal of Economics & Management Strategy, 2015, vol. 24, issue 4, 752-785

Abstract: We analyze the design of procurement contracts when the supplier is privately informed about both his innate production capacity (K) and his innate unit cost of production. We identify conditions under which the supplier will strategically employ an inefficient production technology to expand output above K. We also show that when the buyer employs the simple fixed‐price cost‐reimbursement (FPCR) contracts in the setting examined by Rogerson (2003), the supplier has no incentive to exaggerate K. Furthermore, the buyer can secure with FPCR contracts at least 75% of the surplus she secures with fully optimal contracts.

Date: 2015
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