When More is Less: Defense Profit Policy in a Competitive Environment

Author(s): Anthony G. Bower and Kent Osband

Reviewed work(s):
Source: The RAND Journal of Economics, Vol. 22, No. 1 (Spring, 1991), pp. 107-119
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 RAND Journal of Economics
Vol. 22, No. 1, Spring 1991

When more is less: defenseprofitpolicy

in a competitiveenvironment
AnthonyG. Bower*
and
Kent Osband* *

Prices on some Departmentof Defense (DoD) procurementcontractsare determinedby

competitivebids, whileon otherspricesare negotiatedon the basis of so-called"DoDprofit
policy," wherebyprice is equatedto expectedcost plus a percentagemarkup.This article
focuses on the interactionbetweenthese two contractualarrangements.Specifically,it is
assumedthatan initialcontractis let competitively,withcommonknowledgethatthe winner
will laterbecomea monopolistregulatedaccordingto profitpolicy. Undertheseconditions,
it is shownthat expectedcontractorprofitandgovernmentexpenditurecan oftenbe reduced
by raisingtheprofitpolicymarkup.Theintuitionis not onlythatfirms "buyin"to the initial
contracts,but also that the differentialsubsidizationinducedby profitpolicy (higher-cost
producersreceivelargerabsolutemarkups)encouragesmoreaggressivecompetition.Math-
ematically,this seeminglyrestrictiveregulatorysetupis shownto generalizetheMcAfeeand
McMillan(1986) procurementbiddingmodel.

1. Introduction
* The Departmentof Defense (DoD) takestwo differentapproachesto the assignment
and pricingof procurementcontracts.Some contractsare let competitively,with prices
determinedby sealedbids. Othersare negotiatedwith sole-sourcesuppliers,usingso-called
"profitpolicy"as a basis for pricedetermination.Under profitpolicy, negotiatorsrely on
past cost experience,as verifiedby audits,to estimatefutureexpectedcosts.' Targetprice
is intendedto coverexpectedcostsplus a targetfee or "profit"equalto a percentagemarkup
over expectedcost. The markupvariesby compositionof outlaysand assessmentof per-
formanceand contract-typerisk,accordingto the rulesset forthin the "weightedguidelines."
If actualcosts deviatefrom expectedcosts, the supplieron a negotiatedcontractmay
bearadditionalrewardsor penalties.A firm-fixed-price (FFP) contractis closestin structure

*RAND Corporation.
**The InternationalMonetaryFund.
Researchforthis articlewasfundedby the Officeof ProgramAnalysisand Evaluation(PA&E),Officeof the
Secretaryof Defense,andby RAND Corporation. The authorsthankDavidBaron,Dave McNicol,JohnNachbar,
StefanReichelstein,and an anonymousrefereefor helpfulcomments.
' Contractorsarealso requiredto submitcost estimatesandto certifythatthe estimatesarenot intentionally
fraudulent.The prospectof futureauditinghelps keep contractorsfrom misreportingcosts, but obviouslythere
remainsscope for strategicbehavior.

107
108 / THE RAND JOURNALOF ECONOMICS

to a contractawardedby sealedbids:the supplierbearsthe entireburdenof cost overruns

and pocketsthe entiresavingsfromunderruns.Undera cost-plus-fixed-fee (CPFF)contract,
the supplieris reimbursedits actualcosts plus the targetfee. Undercost-plus-incentive-fee
(CPIF) or fixed-price-incentive (FPI) contracts,the supplierbearsa constant fractionof
cost underrunsor overruns(subjectto possiblecost floorsor ceilings).
For all the legal distinctionsbetween competitivelylet and negotiatedcontracts,in
practicethe two contractualapproachesoften overlap.A competitivelylet contractmay
lead into a negotiatedfollow-oncontract,or vice versa.Evena singlecontractmay change
midcourse,as for examplewhen designor deliverychangeson a competitivelylet contract
triggernegotiationsover fairpayment.
The interactionbetweencompetitionand negotiationis extremelycomplex.This article
focuseson one particularmodel withinthe broadtheme of "competitionto be a regulated
monopolist."Our model assumesthat an initial contractis let competitivelyto the low
bidder,withcommonknowledgethatthewinnerwilllaterreceivea singlesole-source"follow-
on" contractnegotiatedaccordingto profitpolicy.Althoughstylized,the model is farfrom
irrelevantto DoD practice.In 1986, competed contractsaccountedfor 57%of the $78
billion procurementbudget,and follow-oncontractsfor 23%.2Priceis rarelythe sole con-
siderationin contractaward,but obviouslyit is a significantone. Moreover,its importance
appearsto be growingunderpoliticaland budgetarypressures.
Ourpurposeis to studyincentiveswithinthe contextof currentpracticeanddetermine
the optimalcontractwithinthat framework.3 The analysisis not particularlycomplexfrom
a technicalstandpoint,althoughwe do allowfor both privatebiddinginformation(adverse
selection)and discretionarylearning(moralhazard).Butthe resultsruncompletelyagainst
the grainof popularthinkingaboutcost-plus,negotiatedcontracts.To illustratethis claim,
considerthe followingseeminglyreasonablepropositionsaboutthe model.
(1) There is bound to be substantialinefficiencyrelativeto the first-bestfull-information
outcome.
(2) Inefficiencyis greater,the greaterthe procurement"weight"of negotiatedcontracts
relativeto competitivelylet contracts.
(3) Total expenditurestend to risewith the size of the profitpolicy markup.
(4) Highermarkupsare more lucrativefor contractors.
(5) Governmentnegotiatorscan neverbenefitfromusingbiasedcost estimates.
Our analysisshowsthat each of these propositionsis false.The factorthat drivesour
resultsis that firmsmust bid for the rightto have a profitpolicy contractlater.The fun-
damentalintuitionis thatpositiveprofitpolicymarkupsserveto encouragemoreaggressive
bidding.All firmstry to "buyin" to the initialcontracts,and higher-costproducerstry to
buy in more than lower-costproducersbecausethey standto receivelargerabsoluteprofit
marginsif they win. Hence expectedexcess profit marginsare shaved,and may drop to
zero shouldthe markupbecome sufficientlylarge.
The argumentmay be rephrasedin terms of "handicapping."It is well known that
when abilitiescan be observed,the more able competitorsshouldbe penalizedrelativeto
the less able. Underprofitpolicy,proportionalmarkupsdifferentiallysubsidizethe higher-
cost producers.The handicappingtendsto be self-correcting, exceptforthe disincentiveby-
productsof the auditingprocedureused to identifycost. Also, highermarkupsdiscourage
feasiblecost reductionsat the competitivestageof the project.To encouragecost reductions,
the governmentshould try to write the final negotiatedcontractas soon as possibleafter
the initial contractis written,or alternatively,to base negotiatedprice on a cost estimate

2 Source: Secretary of Defense, Annual Report to Congress FYI 988.

3For the unrestricted caseand a comparisonof the two models,see Bower( 1990).
 BOWERAND OSBAND / 109

that ignoresfirst-periodlearning.In principle,eitherof these procedurescan yield the first-

best outcome.
Both in theoreticalformulationand in the thrustof the analysis,this articleis most
closely relatedto workby McAfeeand McMillan(1986). Like us, McAfeeand McMillan
modelthe competitionforgovernmentcontractsin the presenceof moralhazardandadverse
selection.Unlike us, they focuson the impactof cost-shareparametersin a one-stagemodel.
Auditingof costs occursonly at the veryend of the procurementcycle. Nevertheless,they
too identifya handicapping-type effect.Indeed,the presentarticlewas inspiredby the re-
alizationthat the reducedform of our two-stagemodel resemblesthe McAfee-McMillan
structure.
Two articlesby Laffontand Tirole(1986, 1987) addressmany of the same themes as
McAfee-McMillan,in a slightlydifferentcontext. McAfee-McMillanacceptfor modelling
purposesthe institutionalrestrictionthat the cost-shareparameteris fixedpriorto bidding.
Laffontand Tirole derive optimal contractswhen this restrictionis dropped.They show
that the optimalcontractfor risk-neutralsuppliersis indeedlinearin ex post cost but that
lower-costbiddersshouldbe inducedto accepthigher-costshares.4
Our majorpurposein studyingthis set of contractsis twofold:First,we bringtogether
theoreticalcontractingliteraturewith actualDoD practices.We demonstratethat at least
one type of currentDoD contractis closer to the theoreticaloptimal contractliterature
than previouslyrecognized.This is not to claimthatcurrentDoD profitpolicyattainsnear-
optimality.DoD policyappearsto be directedas muchtowardregulatorynotionsof fairness
as towardefficiency,without a clear focus on either. But, in this case at least, the DoD
contractstructureis capableof attainingnearlyoptimal results.Second, we draw several
policy recommendationsfrom our analysis.Thus, our articlefocuseson bridgingtheory
and practiceratherthan on extendingthe puretheoryof contracts,althoughwe do derive
severalnew results.
The next section developsthe basic model without normal hazard.Moral hazardis
addedin Section 3. Section4 concludes.

2. The model without moral hazard

I Consideran industrycomposedof n risk-neutral,profit-maximizingfirms.Each firm
hasa cost C, whichis drawnindependentlyfroma distributionFwith support[Cmin,Cmax].
F is common knowledge.The firm'scost is its privateinformation(we avoid subscripting
C by firm for laternotationalconvenience). We assumethat the firmshave perfectinfor-
mation about their costs priorto bidding.'Each firm'sreservationvalue, or opportunity
cost, is set at zero. The governmentwishesto minimizeprocurementexpendituresfor one
unit of the procuredgood;qualityis assumedto be set independentlyof contractors'bids
and performance.
The game proceedsas follows.At time t = 0, firmsbid via a second-pricesealed-bid
auctionfor an initialfirm-fixed-pricecontract,whichwill last untiltime X.Althougha first-
is in
price auction actuallyused practice,we use a second-priceauction becauseit yields
simple, dominantstrategiesfor the players.However,Myerson( 1981) has shown that the
expectedrevenuesof a first-and second-priceauction are identicalif the biddersare risk
neutral,theirvaluationsareuncorrelated, andthe seller(viz., the government)hasa valuation
sufficientlyhigh. Ourmodel satisfiestheseconditions,and hencewe can use a second-price
auction without loss of generality.After the bid at t = 0, the contractis awardedto the

4Rogerson( 1987) providessome insightsinto why optimalcontractstakethis form.

'See Riordanand Sappington(1986) for a model in which firmsgatherinformationabouttheir product
costsover time.
110 / THE RAND JOURNALOF ECONOMICS

lowestbidderat the second-lowestbidder'sbid. The winningfirmproducesthe good con-

tinuouslyat a rateof 1 per unit time.
It is common knowledgethat at time Xa sole-sourcefollow-oncontractlastinguntil
time 1 will be issuedto the winnerof the firstcontract.Therewill probablybe some design
changesto the good;for conveniencewe will assumethat the cost of the designchangesis
zero. (In general,assumptionsof a determinatesecond contractcan be relaxedwithout
drasticimpacton the model.) Pricefor the secondcontractwill be calculatedaccordingto
profitpolicy,as estimatedcost plusa proportionatemarkupm. Estimatedcost will be based
on auditedfirst-periodcost, so paymentwill equal (1 + m)C per unit time. We assume
that the governmentcan audit costs perfectly;we loosen this restrictionat the end of Sec-
tion 3. As shown in Laffontand Tirole ( 1986), the generalizationto uncertaincosts or a
noisy monitorcan be made easily.At time 1 the gameends.The gameis playedonly once.
One may wonderwhy in practicethe governmentdoes not simplywritea singlecon-
tingentcontractcoveringall projectworkfrom time 0 to 1. Thereare severalreasonswhy
this does not happen.Full contingentcontractsare difficultto write,especiallyfor military
procurementssubjectto rapidchangesin both technologicalopportunitiesand assessments
of need, which stochasticallyshift costs. As it is, major DoD contractsand supporting
documentstypicallyrun to thousandsor tens of thousandsof pages.Even if contingencies
couldbe spelledout, DoD officialsmightbe unwillingor unableto committo futureactions
becauseof lackof budgetaryauthority,fearof possiblepoliticalrepercussions, or uncertainty
aboutfutureDoD policy.
An alternativeview of the modelis thatthe initialcontractspansthe entireprojectbut
that a designchangetriggeringnegotiationis anticipatedat time X.The old contractfor the
periodXto 1 will in effectbe abandoned,replacedby a contractpricedaccordingto profit
policy.
Denote C' as the ith-lowestcost, and thus Ci representsthe ith-orderstatisticfromthe
costdistributionF(C). Paymentsfromthe governmentareassumedto be madeat a constant
rate. This roughlycorrespondsto governmentpracticefor pure cost-plus-typecontracts,
but not for incentivecontracts.On the latter,a portionof the costs, roughly80%,is paid
as the projectproceeds(known as progresspayments),with the remainderpaid at project
completion.This meansthat the presentvalue of markupson incentivecontractstendsto
declinewith projectduration.In particular,it is possiblefor a nominallypositivemarkup
to yielda negativepresentvalue(see Osband( 1988)). We will avoidthis issueby assuming
that all paymentsare convertedinto constantpaymentstreamsof equivalentnet present
value.Costsare assumedto be incurredat a constantrate.
Denote B as the firm's bid. Let B', i = 1, .. ., n be the ith-lowest bid. The firm's bid
B willbe interpretedas a flowof moneyat rateB perunittime.Bothfirmsandthegovernment
discountat interestrater, and the governmentcommitsto m priorto bidding.The winning
firm'sprofit r is

r= (B2 - C)erdt + f ((1 + m)C - C)&redt.

To streamlinethe notation,we set

W= e-rtdt = 1(11-ear)

and

W2= e-rtdt e=r (e-r- )-

 BOWER AND OSBAND / 111

The variable wI is the present value of receiving $1 per unit time from time 0 to time
X, and w2 is the present value of receiving $1 per unit time from time X to time 1. If r = 0,
wI and w2 simply equal the lengths X and 1 - X of the respective two periods. Thus the
profit equation for the winning firm is
r= w(B2 -C) + w2mC,

which can be rewritten as

J = WI(B2-( 1_?m)C) (1 )

Total government expenditures x are profits plus costs to the firm, or

x= wIB2 + w2(1 + m)C.

Observe that x is a linear combination of the bid and cost C, and thus this two-period
contract has been reduced to a one-period form, as in McAfee and McMillan (1986).
McAfee and McMillan assume a contract form P = (1 - a)B + aC, with the cost share
a < 1 (i.e., the firm faces an incentive contract). In our model this corresponds to the con-
dition w2(I + m) < w1 + w2, or m < w1/w2. From inspection of ( 1), we can see that if
m < w1/ w2, then the firm faces an incentive contract. Thus, at this juncture we could appeal
directly to McAfee and McMillan, Theorem 2 for our results. However, to aid the intuition,
it is worthwhile to proceed a bit further with the analysis of the bidding strategies of
the firms.
Our use of a second-price auction facilitates the analysis, because a winning firm's
profit on the contract is independent of its bid. It follows that each firm i has a dominant
strategy of bidding its true cost, or

Bi= (i --m)Ci. (2)

WI

(Substitute (2) into (1) to verify that this is the equilibrium.) The lowest-cost producer
receives the contract, and it receives the second-lowest virtual cost (1 - 2 m)C2 in

payments.
From the government's perspective, the expected profit, ex ante (i.e., before any firm
knows its cost), of the winning firm is
Enr] = (wI - w2m)(E(C2) -E(Cl)),

where, again, C' and C2 representthe first-and second-order statistics of F. Note that profits
decrease as a function of m. This is the key insight of our model. In McAfee-McMillan this
is called the "bidding competition" effect. Evidently, the government can overcome the
adverse selection of unknown costs by correctly designing the auction and contract. In
equation ( 1), the term w2mC represents second-contract profit, and is increasing in C.
Thus, higher-cost firms make more second-contract profit than low-cost firms, which offsets
some of the cost advantage of the low-cost firm. Each firm takes this into account when
bidding for the contract. Hence high-cost firms bid more aggressivelywith higher markups,
which shaves the expected profits of the low-cost firms.
Define m' = w1/ w2. Expected government expenditures are
E(x(m)) = wE(B2) + w2(1 + m)E(C')
- wE(C2) + w2E(Cl)-mw2(E(C2)-E(C')), if m < mx.
1 2 / THE RAND JOURNALOF ECONOMICS

If m = m', firms bear no cost to producethe good, and so all firms bid zero. In that
case the governmentcannot identify the lowest-costproducerand pays in expectation
E(x) = (w, + w2)E(C). Thus it is optimalto impose some cost strictlygreaterthan zero
on the firm. The governmentminimizestotal expendituresby settingm as high as it can
(within, say, e of m') while still selectingthe low-costfirm.
The resultsare summarizedin the followingproposition.See Figure1.
Proposition1. Given privateinformationaboutcostsbut no moralhazard,the government
can approximatearbitrarilycloselythe first-bestsolutionby settingm = w1/ w2- E, with e
arbitrarilysmall.The governmentpaysthe lowest-costfirm(slightlyover) its cost, and the
firm makes(almost) zero profit.
Our resultis closelyrelatedto a resulton auctionsby Riley ( 1988). Riley examinesa
pure "oil-lease"auction in which a signalthat is correlatedwith the buyer'svaluationof
the object,such as the numberof barrelsof oil obtainedfromthe leasedland,is observable
ex post. In our model, the signal correspondsto auditedcost and the buyer'svaluation
correspondsto the firm'sinitial cost C. Riley shows that seller revenuesincreasein the
royaltyrate,providedthatbuyerprofitsaremonotonicincreasingin the signal.In ourmodel
the equivalentstatementis that governmentexpendituresdecreasein m, providedthat
profitsdecreasein C-or, in otherwords,providedm < m'. The markupm playsa similar
role as the royaltyrate.Note that expectedexpendituresjump up at exactlythe point that
monotonicityof profitin auditedcost is violated.
It is curioushow a seeminglyinefficientcost-basedreimbursementschemecan provide
a tool for cost reduction.The key is the interactionwith competition.Cost-basedreim-
bursementhelps the weakest(highest-cost)firmsthe most, yet it need not help them so
much that they actuallywin the contract.The auction then recapturesthe excess profits
from a high markup.Hence, pureauctionsand purecost-pluscontractsare outperformed
by a hybridof the two. McAfee-McMillanand Laffont-Tirole bothconsiderlinearincentive
schemesand find that incentivecontracts,with some cost sharingby the government,are
optimal.Our resultis closely relatedto theirs,becauseour markupm playsthe same role

FIGURE1

E [x],E [n]

(w1+w2)E[CJ?1

(w C EXPECTEDGOVERNMENT
(w1+w2)r2)ELCJ
r XPENDITURE

(w1+w2)E[C1']

(w1+w2)(E[C2 - E [C1') EXPECTEDFIRM

PFT

-1 mX
 BOWER AND OSBAND / 113

as their "cost-shareparameter":it providesa way to reimbursefirmsfor their costs. The

resultis perhapsmore strikingin this context becauseit seems at firstglance so counter-
intuitive.Of course,by now we hope to have conveyedthe correctintuition.
Anotherstrikingfeatureof the model is the "knife-edge"characterof the result.For
the government,cost minimizationlies within e of cost maximization.Hence if there is
uncertaintyabout the relativeweights w, and w2, regulatorsshould err on the low side
ratherthan the high in the choice of m. As we shall see, knife-edgephenomenarecedein
importanceonce cost-reducingeffortis introducedinto the model.
Observethat at the optimum,firmsbuy in to the firstcontractwith a lowballbid and
then recovertheir outlays on the second contractvia a generousmarkup.If DoD cannot
be trustedto follow throughon the secondcontract,this is not a viablesolution.
Moreover,evena DoD thatintendedto implementoptimalcontractsmightbe prevented
fromdoing so. The extremevariabilityof paymentflowsfromcontractto contractis almost
bound to invite politicalintervention,as interestgroupson each side try to adjustcontract
provisionsin their favor.As Baron( 1988) has shown, ex post correctiveaction by lobbies
is likely to reducelong-runexpectedwelfare.In our model, as in Baron's,lobbyingtends
to be counterproductive for the lobbyitself.Restrictionson maximumcontractmarkups-
typicallyfavoredby public"watchdog"groups-can serveto raiselong-runexpectedprofits,
while floorson minimum markups-presumablyfavoredby contractors-can serveto re-
move profitentirely.These resultsarisedirectlyfromour earliercounterintuitiveresultthat
profitand governmentexpendituresare often decreasingin the markup.

3. The model with moral hazard

* We now introducethe possibilityof unobservablecost-reductioneffortby the firm.Not
unexpectedly,profitpolicywill affectthe equilibriumlevel of effort.Highmarkupswill tend
to retardcost reduction.Hencethe presenceof moralhazardcan reducethe optimalmarkup,
as the governmenttradesoff decreasedinformationrentsto firmsin the biddingphasewith
increasedrealizedcost reductionsduringthe productionphase.
We will construeeffortas an investmentin permanentimprovementsin production
technique("learning"),so thatcostsfallwithcumulativeeffort.Specifically,we will assume
that a firmthat exertseffortmi(m7i
? 0) over a perioddt will lowerits costs permanentlyby
mindt. Note that this cost reductionis independentof the firm's cost. Effortimposes a
disutility on the firm of 4,( -), with the usual assumptions on 4,( -): Vf(0) = 0, 4/' > 0, and
"'> 0. In particular,the marginaldisutilityof effortincreaseswith effort.To ensurethat
the second-ordercondition for a solution is satisfied,we will need the furtherassumption
that /f"i> 0.6
In this section we will assume that the firm has only two opportunitiesto set effort:
it sets 77,at the startof the firstcontract(t = 0) and 2 at the startof the second contract
(t = X). The time path of costs is as follows. From t = 0 to t = X, costs drop linearly from
C' to C' - X11. From t = X to t = 1, costs drop steadily from C' - X711 to

C' - 1 -( X-)2

Total first-periodcost C, to the firmis

Cl= f (Cl - i71t)e-rtdt = wC' - v1t1, (3)

6 This assumptionis also usedin Laffontand Tirole( 1986, 1987).

114 / THE RAND JOURNALOF ECONOMICS

where v, - (wI - Xe x). The coefficient v, represents the present value of direct first-
r
contractcost reductionson first-periodcost. The governmentobservesaveragefirst-period
cost C' - 77,and basessecond-periodrevenueson it. Total second-periodcost C2is

C2 = f (C' - -nIX- (t - X))e rfdt = W2(C' - IIX) - V272, (4)

1
where V2 - (w2 - X( - e-r) -r). The coefficient v2 represents the present value of
r
directsecond-periodcost reductionson second-periodcost. Profitis
Or= wIB - Cl + W2(1 + M)(CI - Xn/2) -C2 - wqlA(7) -W2V/(n2)- (5)

Substituting(3) and (4) into (5) yields

W2
Jr= WI(B2 - (1 - mC') - w2( 1 + m)77X/2

+ V171 + w27,X + V2fl2 - W/(71) - W2t(772). (6)

All termsof the profitequationare measuredin presentvalue.The firsttermrepresentsthe
bid minusthe cost incurredin the firstperiod,plusthe second-periodprofitsfromthe profit
policy.The secondtermis the second-periodrevenueloss fromfirst-periodcost reductions.
The third and fourthterms are the first-periodand second-periodgains from first-period
cost reduction,respectively.The fifth term is the second-periodgain from second-period
cost reduction,and the sixth and seventhterms are the directcosts of first-and second-
periodeffort,respectively.The firmcontrolsx71and fl2 and maximizesprofit.Note that the
moral hazardterms are linearlyseparablefrom the cost terms-there is no interaction
betweeninitial cost and effort.
Differentiationof (6) with respectto 77,and fl2 establishesthat the profit-maximizing
level of effortXl and t7* satisfy "( i7*) =V2 and
W2

VI
w +X2w, (IM) (7)

Note that second-periodeffortis set at the first-bestlevel 2 becausethe firmgets to keep

W2
all of its cost reductionsin the secondperiod.In the publicutilityliteraturethis is known
as a "regulatorylag" effect. First-periodeffort is distorteddownwardsbecauseof moral
hazard.The firm facesthe constraintthat mi? 0, thus 4'(21)2 0. This impliesthat for all
m > M=- l + 1, q = 0. This must be taken into account in the government'scost-
XW2
minimizationproblem.
Profitsin (6) can be writtenin a simplerform as
r = wIB2 - (wI - w2m)C' + V*(m),

where V*(m) is the net gain from effortand representseverythingafterthe firstterm in

equation(6), with effortin periods1 and 2 set optimally,or

V*(m) = -W2(1 + m) 2r*(m) + vnl*q(m) + Xw2q (m)

2 - * -

+ V2?12' - W141(n4'(M)) -W2Iq2)

 BOWERAND OSBAND / 115

Since V*(m) does not varyfromfirmto firm(hereis wherethe assumptionof cost reductions
being independentof previouscost becomeskey), these net gainsget bid awayby the firms
and entirelycapturedby the government.

Lemma. Given adverseselectionwith linearlyseparablemoral hazard,a firmwith cost C

will bid (I- - m) C - V*(m)!w1. Profits are the same as in a pure adverse-selection

model;all cost-reductiongainsare capturedby the government.

However,the size of those gains dependsinverselyon m, so the governmentfaces a
cost reduction.
trade-offbetweenincreasedbiddingcompetitionversusincreasedfirst-period
To solve for the optimal m, we startby writingexpectedgovernmentexpendituresas

E(x(m)) = wE(B2) + W2(1 + m)(E(C1) - 2 71*(M)

= (w - w2m)E(C2)-V*(m) + w2(1 + m)(E(C1) -

2 (m)) (8)

For now, assumethat the constraintsm ? mXand a, > 0 do not bind. The derivationof
the first-ordercondition for m is simplifiedby usingthe envelopetheoremto derive
OV*(m) = - X
=-__ - w2fli(m).
am 2
Takingthe derivativeof (8) with respectto m establishesthat

E(C2) - E(C') = --(1 +m) dm ''(9 (9)

2 +tzX dm
wherem denotesthe optimalmarkup,whichis assumedto be an interiorstationarypoint.
To determine 711, differentiatethe equilibriumcondition(7 ) for 77' to obtain
dm

_7 -= X2 (10)
dm 2w1
Combinationof (9) and (10) yields an implicitexpressionfor m:

m = ' "('r ) X2 (E( C2- E(C')) - . (11)

It is easily checked that a sufficientcondition for the second-ordercondition to be

satisfiedis i' 2 0. Equation( 11) identifiesthe optimalm giventhatthe constraintsdo not
bind. However, if m > m w_ / w2, then firm profits will increase in C, as can be seen
from the inspectionof the firstterm of (6). Thus, it is still the case that m is constrained
to be lessthan mX.Also, if m 2 m - 2v+ 1 (i.e., the first-orderconditionon first-contract
XW1
effortrequires77,< 0 in orderto be satisfied),the firmapplieszeroeffortin the firstperiod.
The effectsof the constraintsare taken into accountin the optimalprofitpolicy, which is
outlined in Proposition2. The proof involves straightforward checkingof the constraints
and is omitted. The three key propertiesare first,if m' 2 m > mo, then governmentex-
pendituresare decreasingin m; second, if mo 2 m 2 ml, then governmentexpenditures
are increasingin m; and third, if m 2 mo and m 2 max {mi, mX}, then government
expendituresare constantin m.
 OFECONOMICS
116 / THERANDJOURNAL

Proposition2. Let mAdenote the closestfeasiblemarkupto mxthat is less than m'. Under
moralhazardand adverseselectionthe governmentminimizesexpendituresat

M
mA if m min {m0, m}
m if < MO
m<mXmO
m*
M* = __
|m if <M
m<mO?m X and x(n) <x(m)
m
M. if <M
m<mO?M and x(m) < x(n).

If the interestrate is zero, then mO - 2* X2/2 + 1 = + 1 > m' and Proposi-

tion 2 simplifiesto a

Corollary.If r = 0 then the governmentminimizesexpectedexpendituresat

m* =min {mn,mn}. (12)

Figures2 and 3 illustratethe corollary,which recallssimilarresultsby McAfeeand

McMillan(1986). Figure2 shows an example where m < m\, and Figure 3 shows the
opposite.In Figure2, governmentexpendituresfall with m at a decreasingratedown to m
and then increase,while profitsdroplinearlyto zero at m\. Again,the intuitionis that the
firm earnsprofitsonly from its informationrents,passingon all cost-reductiongains (or
lack of gains) to the government. In the region [ n, me], government expenditures rise even
as profitsfall, due to the severemoralhazardeffects.The marginalincreasein government
outlaysfor firmprofitsfromloweringm is morethan offsetby the marginalincreasein cost
reductiongains.Thus,in this regionthe preferencesof the two partiesregardingm coincide,
and the governmentdecreasesnet outlaysby stimulatingcost reductionand allowingsome
profits.The governmentallows the winning firm positive profitsin equilibriumto avoid
strongmoralhazardeffects.In Figure3, the governmentalwaysgainsmore fromreducing
profitsthan it loses fromwithheldeffort,and a cornersolutionis obtained.

FIGURE2
(r= 0)
E fxJ,E[in

E [xJ
X)~~'
I I
I I
_ ~~~I I

I I
I l
I I
I IE
[ _ _ _ _ _ _ _

mm m
 BOWERAND OSBAND / 117

FIGURE3
(r= 0)
E [x],E [n]

E~x I M

at~~~ I'
E[ I I

mkm

To gain more intuition as to when a cornersolutionis obtained,considerthe case of

r =0 and quadratic disutility {i(pi) = -K2n*. Then, from ( 11),
2

m> MAX E(C2) - E(C') >-

4K'
Thus, if marginallossesto adverseselection,proportionalto E( C2) - E( C') and constant
in m, are largerthan marginallosses to moralhazardat m = mX,which are increasingin
m and equal to 4K at m = mX,then set m = m. and drivefirm profitsto (almost) zero.
Still assuming quadraticdisutility (f"' = K), a number of comparative-staticsre-
sults can be gleanedfrom inspectionof equation( 11). The markupm is increasingin the
expectedsize of the pure informationrentsE(C2) - E(C'). One possibleway to shrink
E( C2) - E( C') is to increasethe numberof capablefirmsbidding.The morefirmsbidding,
the smallerthe markupcan be, becausecompetitionis mitigatingthe informationrents.In
principle,markupsshouldbe set on a sector-by-sector or even a contract-by-contract
basis,
to adjustto varyingtechnologicaluncertainties,cost-reducingprospects,and industrycom-
petitiveness.The trendof the lastquartercenturyhasbeenexactlythe opposite:to standardize
markuppolicy. This may have advantagesfrom the perspectiveof internalgovernment
monitoringand avoidanceof congressionaloversight,considerationsthatour modelignores.
But direct contractingefficiencyappearsto be sacrificed.Finally, the markupis directly
proportionalto K; a high K implies that changesin markupswill have smallermarginal
influenceon first-periodeffort ,*1.
IJ Biased and imperfectauditing.The model can be generalizedto allow for different
auditingproceduresand for cost-sharingon the second contract.Our auditingbaseline
assumedthat the governmentobservestotal cost on the firstcontractand uses that as an
estimate of second-contractcost. Now allow auditorsto observecosts at differenttimes
withinthe firstcontractand to use that informationto form an estimateC' - s Xn - S of
averagesecond-contractcost. The parameters representsthe proportionof first-periodcost
reductionsincluded in the estimate,and S representsa lump sum, possiblyan a priori
118 / THE RAND JOURNALOF ECONOMICS

estimate of second-contractcost. For example, the baselinecan be expressedas s =

S = 0. If s = I and S = 1-n2 , the auditorwill have an unbiasedestimateof costs for

2
the second contract.Estimatesfor which s is less than 1 will be called "lagged"because
theyarehistoricalmeasuresand overestimatefuturecost,whileestimatesforwhichs exceeds
1 will be called"leading."We also allowforthe governmentto beara share1 - 0 of second-
contractcost underrunsor overruns.The parameter0 is calledthe (contractor's)cost share,
and it will be allowedto varybetween0 and 1. Ourbaselinecase sets 0 equalto 1.
Observethat S has no effect on choice of effort,firm'sprofit, or total government
expendituresbecauseit is simply a lump-sumpaymentthat does not vary from firm to
firm. S is completelybid away in the auction in a fashionsimilarto the efficiencygains
V*(m). The remainingparameterss and 0 changethe first-orderconditionsfor effortto
VI W2
i *V') v,+ - (O - Os- is) (13a)
WI WI

and

{'(n2 ) = 0-. (13b)

W2

Equation( 11) for m is replacedby

V(n I W(E(C2
- - E(Cl)) - 1. (14)
in s2x2W2
From inspectionof (1 3b) we see that second-contracteffortincreaseswith 0 and that
second-contract effortis independentof s. Also, from( 13a), first-contracteffortis decreasing
in s. It follows that a lagged estimate (s < 1) is superior to an unbiased or leading estimate,
since the governmentreducestotal outlaysthroughstimulatedcost-reductioneffort.The
optimal m increases as s falls, until eventually the constraint m < mi binds. The efficiency
loss fromthe constraintdiminishesas s approacheszero.
In the limit, with s = 0 and 0 = 1, incentivesfor cost reducingeffortare first-bestin
each contract,as can be seen from (13a) and (13b). Optimaleffortis higherin the first
learningcarriesoverto the secondcontract
contractthan the second,since all first-contract
but not vice versa.Whens = 0 in the limit, cost estimatesno longerdependupon variables
subjectto moral hazard.Manipulationof the markupsqueezesthe informationrentsout
of the winnerof the auction,while the two firm-fixed-price contractsare independentand
impose no effortpenalty.We do not claim that such carefulmeasurementis feasible-in
particular,for the governmentto use a particulars in its cost estimation,it is necessarythat
costs be observableat time Xs. For small s this will not be feasible.But the resultclearly
illuminates the underlying logic of the model and the pivotal role of audit timing. Results
are summarizedin
Proposition3. Efficiencyis improvedby using laggedestimatesof second-periodcosts and
highercost shares.As lag and cost sharemove to s = 0, 0 = 1, procurementcost in the limit
approachesthe first-best.
One moregeneralizationconcernsthe possibilitythatmonitoringis imperfect.Suppose
costs(at whatevertime) plusadditiverandomdisturbances.
thatauditsmeasurefirst-contract
The disturbancetermswill enteras separatetermsin the firm'sprofitequation(6). Since
the firm is interestedin maximizingexpected profit,the randomdisturbanceterms will
drop out. Providedthose disturbancesare independentof true costs, neitherthe noisiness
 BOWERAND OSBAND / 119

of the measuresnor possiblebiaseswill affecteffortchoice or expectedoverallpayments.

Thus, if firmsare risk neutral,then a linearcontractis optimaland the Laffontand Tirole
(1986) resultholds here as well. Of course,for largedisturbances,risk neutralitymay not
be a good assumption.

4. Conclusion
* Governmentexpendituresgenerallydecreasein m for small m, due to biddingcom-
petitioneffects.The optimalmark-upm * is low only when the distributionof costs is tight
(i.e., the informationon how much it costs to make the productis very good); there is a
low disutilityof effort;and the firstcontractis short.
Firmswill buy in to a contractwith a low bid, expectingto make up theirloss during
the cost-plusstage.The higherthe m, the lowerthe bid. Bids are very sensitiveto m, but
governmentexpendituresare less sensitive.Bids representfirst-periodwealth,and the size
of m has a first-ordereffecton first-periodwealthas higherm moves wealthfrom the first
period to the second period;m has only a second-ordereffect on the overall amount of
wealthas it retardsfirst-periodeffort.The effectm has on revenuedistributionover time is
particularlylargeon long-termcontracts,since the componentof the bid V*/ w1gets large
as w, shrinks.Once the correcteconomic institutionalfeaturesare in place, namely, the
auctionand some sort of reimbursementfor costs, governmentexpendituresappearto be
ratherinsensitiveto m over fairlybroadranges.Firmswill bid away excess second-period
profitsduringthe auction.Thus,in a loose sense,havingthe featureof a competitiveauction
is more importantthan the exact level of profitallowedin the second period,becausethe
information-eliciting auctionprovidesthe safetynet of competitionto the government.
This model can be extendedin many ways.An extensionexaminedby Bower(1990)
is to place the model in the general,optimal-contractingframeworkof Laffont-Tirole.In
their modelthe cost-shareparameteris allowedto varywith the bids;in our model, m does
not depend upon the bid. Bowershows that the cost of this restrictionto DoD is usually
quite small.He also examinesthe case of renegotiationat the end of the firstperiodand an
extensionto two or more auditingperiods.

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