 Financial incentives for cost control under moral hazardPeter J. Ryan, Claude G. Henin and Devinder K. Gandhi Omega, 1986, vol. 14, issue 3, 221-231 Abstract: A distinguishing feature of contracted production is that the contractual terms must be agreed upon before the product exists. If the specified product is the result of an innovative and complex process, uncertainties as to its production cost estimates can be enormous. This renders the traditional cost-plus-fixed-fee and fixed-price contractual arrangements increasingly untenable. An alternative contractual arrangement that is currently gaining greater acceptance is the fixed-price-incentive contract, which may be as simple as a linear cost-sharing formula or as complex as a state-contingent reward penalty structure. The problem from the viewpoint of the contractee (principal) is to identify the optimal incentive structure in order to minimize his expected cost; the incentive affects the contractor (agent) through his risk aversion and his propensity for "moral hazard", due to the co-insurance effect of cost-sharing incentives. Taking as premise the contractee's risk-neutrality, the problem is formulated as a constrained optimization problem, with the constraint arising from the returns to each of the parties to the contract. It is thereby demonstrated that the currently popular linear incentive mechanism is ineffective from the viewpoint of the contractee before the introduction of the problem of moral hazard. We then show that, the problem can be segregated into independent components of the contractor's risk aversion and his propensity for moral hazard. Having established this, we proceed to examine the incentive form as related to the "monitoring mechanism" instituted by the contractor during the performance of the contract. Acceptance of the conclusions necessitates that the contracting parties can interpret their objective as the maximization of the ratio of their expected profits to target profits, which is demonstrated as being equivalent to the minimization of the certainty equivalent of costs. Date: 1986 Downloads: (external link) Related works: Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text Persistent link: https://EconPapers.repec.org/RePEc:eee:jomega:v:14:y:1986:i:3:p:221-231 Ordering information: This journal article can be ordered from Access Statistics for this article Omega is currently edited by B. Lev More articles in Omega from Elsevier |
Is your work missing from RePEc? Here is how to contribute.
Questions or problems? Check the EconPapers FAQ or send mail to .
EconPapers is hosted by the
School of Business at Örebro University.