SFB 303 Discussion Paper No. A - 524
Author: Bös, Dieter
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
JEL-Classification-Number: D23, H57, L51
Creation-Date: June 1996
Unfortunately this paper is not available online. Please contact us to order a hardcopy.
SFB 303 Homepage
28.04.1998, Webmaster