Template-Type: ReDIF-Paper 1.0
Author-Name: Dieter Bös
Title: Incomplete Contracting and Target-Cost Pricing
Abstract: Target-cost pricing has been a widely applied formula in defence
  	contracting. If this type of pricing arrangement is chosen,  the
  	seller's ex-post profit consists of a fixed payment plus  some share
  	of the cost overrun, that is the difference between an ex--ante
  	agreed estimation of the production costs and the  actual production
  	costs. In an incomplete--contract setting, where relationship--
  	specific investments have to be made prior to the production stage,
  	the cost-reimbursement properties of target-cost pricing work
  	against a first best. However, since costs are verifiable, the ex--
  	ante contract allows to condition  the initial contract on costs,
  	that is, to stipulate a separate trade price for each cost
  	observation, plus a special price for  the no--trade case. (If costs
  	are non--verifiable, it is only  possible to fix one price for trade
  	and one price for non--trade.) This increase in the number of
  	instruments available to the agents works in favour of a first best.
  	The paper shows that the positive properties of target-cost pricing
  	outweigh  the negative ones: it is possible to find prices which
  	induce the agents  to  invest efficiently into relationship-specific
  	investments, thus avoiding Williamson's hold-up problem. This result
  	is particularly important because fixed-price contracts a la Hart--
  	Moore (1988) fail to achieve the first best if they are applied in
  	the same environment in which target-cost prices succeed in
  	attaining the first best. Since any contract, which implies full
  	cost-reimbursement, also fails to achieve the first best, this paper
  	shows that the first best requires just that middle-of-the-road
  	approach which is offered by target-cost pricing.
Keywords: Procurement, Target--Cost Pricing, Holdup Problem, Incomplete
  	Contracts
Classification-JEL: D23; H57; L51
Creation-Date: 1996-06
File-URL: http://www.wiwi.uni-bonn.de/bgsepapers/bonsfa/bonsfa524.ps
File-Format: Application/PostScript
File-Size: 17
Handle: RePEc:bon:bonsfa:524