A THEORY OF INCENTIVES IN PROCUREMENT

AND REGULATION

Jean-Jacques Laffont
and
Jean Tirole

BIB\..l01'ECA

9742
The MIT Press
Cambridge, Massachusetts
London, England
 COST-REIMBURSEMENT RULES
1
1.1 Sorne Background

Cost-reimbursement rules refer to the extent of cost sharing between the

firm and either the taxpayers or the consumers. The power of an incen-
tive scheme, namely the fraction of the realized cost that is borne by
the firm, is a central notion in policy debates. This notion underlies
views about the relative merits of cost-of-service regulation, profit-sharing
schemes, and price caps (in regulation) and of cost-plus contracts, in-
centive contracts, and fixed-price contracts (in procurement). Section 4
of the introductory chapter (which is required reading for this chap-
ter) pointed at a basic trade-off between rent extraction and incen-
tives. Incentives are best provided if the firm bears a high fraction of
its cost. But reimbursing the firm's cost limits its rent. In this chapter
we begin by formalizing this trade-off and by studying sorne of its
conseq uences.
We take the simplest regulatory situation: The regulator wants to real-
ize a single, fixed-size project. The fixed output allows us to abstract from
the issue of consumer prices. A single firm has the adequate technology.
The regulator designs an incentive scheme so as to maximize social wel-
fare. This is the basic framework that we will use to enrich the model in
order to study variable size and multigood production (this part), product
market competition (part II}, auctioning (part III), repeated relationships
(part IV}, nonbenevolent regulators (part V), and regulatory institutions
(part VI).
The chapter is divided into two parts. The first part (sections 1.2 through
1.6) formalizes the basic trade-off between rent extraction and incentives
discussed in the introductory chapter. Because the present chapter pro-
vides the foundation for the rest of the book, its first sections emphasize
methodology over economic insights. Sections 1.2 through 1.4 are rather
formal. Our goal is to provide ali the steps of reasoning for a reader un-
familiar with information economics. By taking the time to master those
sections, the reader should be able to read almost any chapter in the book
independently of the other chapters. Section 1.2 sets up the model, and
sections 1.3 and 1.4 solve it in detail when the firm's technological in-
formation can take two values or a continuum of values. Despite its meth-
odological function, section 1.4 already yields sorne interesting insights.
Under sorne conditions it is optimal for the regulator to offer a menu of
linear cost-reimbursement rules. The firm chooses a high-powered (low-
powered) cost-reimbursement rule if it is confident that it will produce at
low (high) cost. Furthermore asymmetric information about the technol-
ogy pushes incentive schemes away from fixed-price contracts and toward
cost-plus contracts. These results seem to fit with practica! considerations
as well as with evidence on procurement.
54 Chapter 1

Section 1.5 summarizes sorne economic insights and obtains sorne re-
sults on the effect of changes in technological uncertainty on the firm's rent
and on the expectation of the slope of its incentive scheme. This bare-
bones version of our model als9 anticipates sorne of the main themes of
the book. Section 1.6 discusses the relevance and informational require-
ments of menus of contracts and argues that the insights can be used to
guide regulatory policy.
The second part of the chapter (its last five sections) combines our
model with standard, but important, ideas of the literature on incentives.
Section 1.7 explores the use of "yardstick competition" (also called "rela-
tive performance evaluation") as a way for the regulator to reduce the
asymmetry of information about the firm's cost. The idea here is that the
firm's cost should be compared with those of other firms (possibly in
different geographical markets) facing a similar technology. This section
shows how to modify the cost-reimbursement rules to account for yard-
stick competition.
Sections 1.8 and 1.9 examine the link between cost-reimbursement rules
and investment. An investment stage is added prior to the production
stage studied in the first part of this chapter. Section 1.8 assumes that the
regulator and the firm can sign a (long-term) contract defining the cost-
reimbursement rule for the production stage before the firm invests; it
considers two polar cases in which the two parties can or cannot con-
tract on investment. This section recasts the traditional policy debate on a
"fair" and "reasonable" rate of return on investment as a problem of in-
ducing the appropriate investment behavior from the firm. It derives the
optimal setting of the rate of return on investment and analyzes the link-
age between the incentive to invest and the incentive to reduce operating
costs when the firm has superior knowledge about either the cost of in-
vestment or its effectiveness. Section 1.9 uses the model to study another
familiar issue in regulatory economics: In the absence of a detailed long-
term contract, the regulated firm may refrain from investing in the fear
that once the investment is in place, the regulator would pay only for
variable cost and would not allow the firm to recoup its sunk cost. The
section demonstrates the link between the regulator's rent extraction con-
cern and the underinvestment problem. It then studies the benefits and
limits of four factors conducive to investment: indirect measurement of
investment, long-term contracts, regulator's reputation, and existence of
related commercial activities.
Section 1.10, to be reread before tackling chapters 9 and 10, shows the
"false dynamics" of a repeated relationship in which the government and
the firm can commit to a long-term contract but are unable to renegotiate
it. The regulator optimally commits to the repetition of the optimal static
contract. Section 1.11 analyzes the effect of firm's risk aversion on the
55 Cost-Reimbursement Rules

power of the incentive schemes. Bibliographic notes and technical a ppen-

dixes conclude the chapter.

1.2 The Model

We consider the simple case of an indivisible public project that has value
S for consumers. A single firm can realize the project. Its cost function is
e = (J- e, (1.1)
where {3 is an efficiency parameter and e is the managers' effort. For ex-
positional simplicity we will assume that efforts remain strictly positive
over the relevant range of equilibrium efforts. 1 lf the firm exerts effort
leve] e, it decreases the (monetary) cost of the project by e and incurs a
disutility (in monetary units) of l/J(e). T his disutility increases with effort
l/J' > O for e > O, at an increasing rate 1/1" > O, and satisfies 1/1(0) = O,
lime~pl/J(e) = + oo.
We first assume that cost is observable by the regulator, and we take the
accounting convention tha t cost is reimbursed to the firm by the regulator.
To accept work for the regulator, the firm must be compensated by a net
monetary transfer t in addition to the reimbursement of cost. Let U be the
firm's utility leve!:

U= t - 1/J(e). (1.2)

In its relationship with the regulator the firm must obtain at least as much
utility as outside the relationship. We normalize the firm's outside oppor-
tunity leve! of utility or "reservation utility" to O. 2 The firm's individual
rationality (IR) constraint is accordingly

t - l/J(e) ;::::: O. (1.3)

Let A. > Odenote the shadow cost of public funds. T hat is, distortionary
taxation inflicts disutility $(1 + A.) on taxpayers in order to levy $1 for the
state. T he net surplus of consumers/taxpayers is

S - (1 + A.)(t + {3 - e). (1.4)

For a utilitarian regulator, ex post social welfare is

S - (1 + A.)(t + {3 - e) +t- l/J(e) = S - (1 + A.) [{3 - e + l/J(e)] - A.U.

(1.5)

l. There is no difficulty in allowing zero or negative efTorts; see appendix A9.9 in chapter 9
for an example.
2. In particular this assumption means that the outside opportunity leve) is independent of
the efficiency parameter. The analysis is unchanged as long as the outside level does not
decrease with p too quickly. See chapter 6 for an ad verse-selection problem with a type-
dependent reservation utility.
56 Chapter 1

That is, social welfare is the difference between the consumer surplus at-
tached to the project and (1) the total cost of the project C + tf¡(e) as
perceived by the taxpayers plus (2) the firm's rent above its reservation
utility times the shadow cost of public funds. The crucial feature of this
social welfare function is that the regulator dislikes leaving a rent to the
firm.
We assume that the regulator is a Stackelberg leader and makes a take-
it-or-leave-it offer to the firm. Under complete information- that is, know-
ing f3 and observing e- the regulator would solve
max {S - (1 + ..1.)[p - e+ tf¡(e)] - ..1.U} (1.6)
{U,e)

subject to U ;::: O. The solution of this program is

tf¡'(e) = 1 or e= e*, (1.7)
U = O or t = tf¡(e*). (1.8)
That is, the marginal disutility of effort, t/J'(e), must be equal to marginal
cost savings, 1 [equation (1.7)]. Furthermore the existence of a shadow
cost of public funds implies that the firm receives no rent [equation (1.8)].
There are many contracts between the firm and the regulator that im-
plement the optima} regulatory outcome defined by these two equations.
For instance, the regulator could give the firm transfer t = tf¡(e*) and ask
the firm to exert effort e* (or equivalently set a cost target C = f3 - e*). If
the firm accepts this contract and exerts less effort than e*, it must pay a
large penalty. More interesting for our purpose, the regulator can offer
the firm a fixed-price contract:
t(C) = a - (C - C*),
=
where a= tf¡(e*) and C* f3 - e*. The firm is then the residual claimant
for its cost savings and therefore chooses e so as to maximize a -
(/3 - e - C*) - tf¡(e); that is, e = e*. Its utility is then U= O. A fixed-price
contract gives the firm perfect incentives for cost reduction; furthermore
the fixed payment a can be tailored to fully extract the firm's rent under
complete information. Note also that this contract shows that the regula-
tor need not observe effort. Indeed as long as the regulator knows p, he or
she can infer effort e = p - C from the observation of cost.
Our objective in this chapter is to alter only one assumption of the
previous framework, namely that of complete information. The regulator
observes realized cost but does not know the true value of p and does not
monitor the level of effort. In section 1.3 we study the case where it is
common knowledge that f3 can take one of two values {~, '/i}, and we
obtain the optima! regulatory rule. The same analysis is carried out in
section 1.4 for the case where p is a continuous parameter belonging to an
57 Cost-Reimbursement Rules

interval [~ , p].
Various exercises of comparati ve statics of the optimal
regulation are performed in section 1.5: effects of a change in the value of
the project, in the disutility of effort, in the uncertainty about /3, and in the
shadow cost of public funds.

1.3 The Two-Type Case

This section assumes that the reguJator knows that /3 belongs to the two-
point support {/3, P} with > {3. We let A{J
P =P-
{3. The regulator ob-
serves the realized cost C and makes a net transfer t to the firm. A contract
between the regulator and the firm can be based on these jointly observ-
able variables. If we exclude stochastic contracts (which we can do without
loss of generality; see appendix Al.1), a contract based on the observ-
ables t and C specifies a transfer-cost pair for each type of finn, namely
{t(~). C(~)} for type ~ and {t("/J), C("/J)} for type p. For notational simplic-
= = =
ity let f t(~), {;; C(~), etc. We let U(/3) t(/3) - 1/1(/3 - C(/3)) denote
the utility or rent of type /3 when it selects the transfer-cost pair designed
= =
for it. [So Jl f - 1/1(~ - 9 and V t - 1/1("/J - C).]
Incentive compatibility (IC) says that the contract designed for type {3
(respectively type "/J) is the one preferred by type ~ (resp. type p) in the
menu of transfer-cost pairs. Noting from (1.1) that e= {3 - C, incentive
compatibility amounts to

f - 1/1(~ - g ~ t- 1/1(~ - C), (1.9)

t - 1/1("/J - C) ~ f - 1/1("/J - !;;). (1.10)

Adding up (1.9) and (l.10) yields

1/1(~ - C) + l/l(P - g - 1/1(~ - g - l/l(P - e) ~ o, (1.11)

or

f: f: 1/1"(/3 - C)d{3dC ~O (1.12)

which, together with t/J" >O and "fJ > ~. implies that

e~!;;. (1.13)

Thus a first implication of incentive compatibility is that C is nondecreas-

ing in {3.
Individual rationality (IR) for each type of firm amounts to

Jl ~O, (1.14)

v~o. (1.15)

Note that incentive compatibility for the efficient type and individual ra-
58 Chapter 1

tionality for the inefficient type imply individual rationality for the effi-
cient type. To show this, we apply successively (1.9), (1.15), and the fact
that t/¡ is increasing:

Q ~ t- t/I(~ - e)
~ t/l(P - e) - t/1(/3 - C)
~o. (1.16)

That is, since the efficient type of firm can always mimic the inefficient one
ata lower cost, we can ignore (1.14).
Ex post social welfare when the firm has type {3 becomes

W({3) =S- (1 + A) [t(/3) + C(/3)] + t(/3) - t/¡({3 - C({3))

= S - (1 + ;.) [C(/3) + t/¡({3 - C({3))] - ;.u(p). (1.17)

The regulator has a prior distribution on the values of {3 characterized by

v = Pr(/3 = {3) and selects the contract that maximizes expected social wel-
fare W = vW(~) + (1 - v) W(j'j) under the IC and IR constraints.
To maximize expected welfare under (1.9), (1.10), and (1.15), we momen-
tarily neglect (1.10), and we later check that the solution of the maximiza-
tion under (1.9) and (1.15) satisfies (1.10). Therefore we retain only the IR
constraint of the inefficient type of firm and the IC constraint of the effi-
cient type.
The IC constraint of the efficient type (1.9) can be rewritten

Q ~ t- t/1(/3- e)
~ u + <I>(e), (1.18)

where

<l>(e) =t/¡(e) - t/¡(e - !1{3) (1.19)

and

e=iJ-c. (1.20)

Since t/¡" > O, <l>( ·) is increasing. Furthermore, if t/¡"' ~ O, <l>( ·) is convex,

which ensures that the regulator's objective function is concave (see be-
low). The assumption that t/¡"' ~ Ois generally not needed for comparative
statics exercises, but it simplifies the exposition.
The function <l>( ·) plays a crucial role in what follows. It determines
the rent of the efficient type of firm (relative to the inefficient type) by
measuring the economy in disutility of effort associated with a better tech-
nology. The implication of the property that <l>( ·) is increasing is that the
firm derives more informational rents under a high-powered incentive
scheme (inducing high effort) than under a low-powered one.
59 Cost-Reimbursement Rules

The regulator's optimization problem is

~ax_ {v[S - (1 + ,l_)~ + i/J(/3 - _r)) - ,l_![J
¡~.e.u.u ) -
+ (1 - v)[S - (1 + ,l_)(C + i/l(P - e)) - ;_UJ}, (1.21)
subject to (1.15) and (1.18). Since the rents U(/J) are costly to the regulator,
the constraints (1.15) and (1.18) are binding at the optimum. Substituting
U= O and ![ = cI>(P - C) in (1.21), we obtain
ij¡'(~ - g =1 or ~ = e*, (1.22)

-- )_V --
i/J'(/J - C) = 1 - - - - - cf>'(/3 - C), implying that e< e*. (1.23)
1+,l_l-v

Note that the neglected constraint (1.10) is satisfied by tbis solution. Tbis
constraint can be written
(1.24)

or
o ~ e1>(p - e) - e1>(fi - _r}, (1.25)

which is true since e < ~ from (1.22) and (1.23) (and therefore e> _r) and
el>' > O.
Thus far we have obtained the optima! deterministic contract. Appendix
Al.l shows that the contract is optima! under the additional assumption
that 1 //" ~O, even in the class of stochastic contracts. Also we have as-
sumed that it is worth realizing the project even with an inefficient firm.
This is the case for S large enough. We will relax this assumption later. We
gather our results in the following proposition:
Proposition 1.1 For S large enough and i/J"' ~ O, optima! regulation un-
der incomplete information is characterized by (1.22) and (1.23). It entails
i. an efficient leve} of effort and a positive rent for type ~.
ii. undereffort and no rent for type p.
The ability of the efficient type to mimic the inefficient type forces the
regulator to give upa rent to the efficient type if he or she wishes to ha ve
an active inefficient type. This rent cf>(e) is a function of the effort level
required from the inefficient type. If the regulator were to insist on the
first-best level of effort, or C = P- e*, the result would be a high rent for
the efficient type (since el>' > O). To reduce the costly rent, the regulator
lowers the effort leve} requested from the inefficient type.
We encounter here a crucial idea of this book. Asymmetric information
forces principals to give up costly rents to their agents. To mitigate these
costs, allocations are distorted away from first-best allocations and to-
60 Chapter 1

'', t- '!'< -~ - e ) = o

\/
'' .., t- '!'(~ - e)= constan!
·· ·· · · · ······ ·•···· · · · · · ····· ·· ·····' ·
- ,/"
'!'(e*)
A : B ........
...........

~ - e* ~-e * e
Figure 1.1
The complete information solution {A, B} is not incentive compatible

ward low-powered schemes. These distortions constitute the regulatory

response to the asymmetry of information.
Let us illustrate the solution in the transfer-cost space: In figure 1.1 the
first-best {~=e= e*,f = t = ift(e*)} is not incentive compatible because
both types prefer contract {if¡(e*), p- e*} (point B in the figure) to contract
{ift(e*), p - e*} (point A in the figure). Figure 1.2 illustrates the optimal
solution. Type pis indifferent between contract {f,~} (point Din figure
1.2) and contraCt {f, C} (point E in figure 1.2). This illustrates the fact that
type P's IC constraint is binding at the optimum. Type Pstrictly prefers
point-E to point D (its IC constraint is not binding), and it obtains no rent
(its IR constraint is binding). Figure 1.2 illustrates why reducing the ineffi-
cient type's effort limits the efficient type's rent. Eliciting effort e* from the
inefficient type would correspond to giving this type point B rather than
point E on its zero-utility indifference curve. But this would require mov-
ing the efficient type to a higher-utility indifference curve (moving from
point D to point G). While the first-best effort levels can be implemented,
for example by the menu {G, B}, it is optimal for the regulator to distort
effort to extract rents.
Figure 1.2 also suggests the following intuitive derivation of e: Increas-
ing C, or equivalently reducing e by one unit, has two effects. The net
production cost of type p increases by 1 - l/t'(e). But type P's rent or
transfer decreases by <l>'(e). The probability of type Pis 1 - v s o that the
expected increase in production cost is
(1 - v)(l + ,1.)[1 - 1f/(e)];

similarly the expected reduction in the social cost of transfer to type ~ is

61 Cost-Reimbursement Rules

1- w< ª- e)= <1>( e)

t - w<~ -e ) =<l>( e • )
: t-ljl ( ~-C)=O
••
••
••
''
ljl( e*)+ et>( e)
o: ' ''
ljl(e* ) ··· ··· ···· ····· ··•····· '
A:
ljl(e)

ª-e * e
Figure 1.2
Guaranteeing incentive compatibility

v.A.<l>'(e).

Point E in figure 1.2 is chosen so that a small move aiong type zero- P's
utility curve generates an equai increase in expected production cost and
a decrease in the expected social cost of transfer. This yields (1.23).

Remark (to be skipped in a jirst reading) By observing the contract

selected by the firm, the regulator iearns the cost characteristic p of the
firm. Suppose, for instance, that he or she observes the choice of point D.
lnferring that p = ~. the regulator would be tempted to keep requiring
cost level ~ = ~ - e* and to reduce the transfer to if¡(e*) to extract the
efficient type's rent. The crucial assumption made here is that the regulator
cannot withdraw his or her initial offer once it is accepted. That is, either
the contract is enforced by a court, or the regulator has developed a repu-
tation for respecting agreements.
A more subtle issue arises in the appiication of the reveiation principie.
Suppose that the reguiator can indeed commit to a contract, say, because
contracts are enforceabie. We mentioned two ways of implementing the
optimai allocation. One is the use of an incentive scheme t(C). That is, the
reguiator offers a contract t( · ). If the firm accepts the contract, it produces.
The reaiized cost C is observed and the reguiator pays t(C). Aiternativeiy,
the reveiation principie (see appendix Al.2) says that the regulator can
offer a direct mechanism {t(p), C(p)}. If the firm accepts this mechanism,
p
it makes an announcement of its parameter. The firm is then required to
produce at cost level C(p), and it receives transfer t(p). Direct mechanisms
62 Chapter 1

suffer from the following drawback: After the firm announces Pand before
effort is exerted, the regulator and the firm could renegotiate their initial
agreement. While {t(P), C{P)} can be enforced if one of the two parties
wants it, both parties may find it mutually advantageous to void the initial
agreement and design a new one. Such renegotiation would not arise should
the firm announce f3 (chooses point D). Effort would then be efficient, and
no renegotiation coÜ!d improve the welfare of both parties. Suppose, how-
ever, that the finn announces type 7i (chooses point E). The effort would be
suboptimal. It would then be optimal to renegotiate to ensure production
at cost leve! 7i - e* and share the gains from trade. For instance, if the
regulator has ali the bargaining power in the renegotiation, he or shc will
offer to alter contract E into contract B in figure 1.2. Anticipating this,
type f3 will strictly prefer to choose contract E over contract D. In other
words, the expectation of renegotiation destroys incentive compatibility.
While, by definition, renegotiation is beneficial ex post, it is never bene-
ficia! ex ante and may even be detrimental. Renegotiation is a concern
in this model only if one uses direct revelation mechanisms. The problem
is avoided in the more realistic incentive schemes t(C) in which the regula-
tor learns nothing about the firm's type until cost is realized, that is, until
there is nothing to renegotiate about (except for the transfer, but no re-
negotiation can occur in this dimension only). 3 But, as we will see in
chapter 10, in a multiperiod model renegotiation of long-term contracts is
a senous 1ssue.
Shutdown of the Firm
It is often reasonable to assume that a regulated firm cannot be shut down,
since there are poor substitution opportunities for electricity, telephone,
and other such basic products. However, in procurement, or in regulation
at the leve! of a project, the regulator could decide to go ahead with pro-
duction only if the cost is sufficiently low. If the regulator decides to shut
down production of an inefficient firm, the optima! contract for type {3
would clearly be {t = if¡(e*), C = Q- e*}. In other words, because the
efficient type now gets no rent by mimicking the inefficient one, the regula-
tor can fully extract its rent. The gain is thus a lower rent for type {3 (note
that not producing is an extreme instance of a low-powered incentive
scheme); the loss is that the good is not produced if the firm has type p.
The regulator prefers to have the two types produce if and only if
v{S - (1 + A.) [Q - e*+ if¡(e*)] - A.<l>(e)}
+ (1 - v){S - (1 + A.) [p - e+ if¡(e)J}
~ v{S - (1 +A.)[~ - e*+ if¡(e*)]}. (1.26)

3. However, it may be useful to have the firm revea! information before performing so that
the regulator could coordinate its activity with that of other firms, or the regulator might
want to shut the firm down, as is studied next.
63 Cost-Reimbursement Rules

Because the derivative of the left-hand side of (1.26) with respect to S is 1

and that of the right-hand side is only v, shutdown occurs only for low
values of S. For instance, when Sis small because there exist substitutes,
shutting down type Pbecomes an attractive option. This suggests that
the firm is hurt by the introduction of competition on its product mar-
ket. Competition reduces the social surplus attached to its production
and makes it more likely that the regulator would shut down the ineffi-
cient type. Competition thus reduces the efficient type's rent. Regulated
firms derive more rents when they are indispensable. Similarly there exists
v0 E (O, 1) such that the regulator shuts down type Pif and only if v > v0 .

1.4 Continuum of Types

We now assume that f3 is a continuous parameter that belongs to the

interval [{3, p]. From the revelation principie (see appendix Al.2) we know
that any regulatory mechanism is equivalent to a direct revelation mecha-
nism that induces truthful revelation of the firm's cost parameter.
Let {t(p), C(p)} pe [ p, PJ be such a revelation mechanism, where Pdenotes
the announcement. T-hat is, if the firm announces a cost parameter p, it
must realize a cost C(p), and it will receive a net transfer t(p). The firm's
utility as a function of the true parameter f3 and the announced one P
is
cp(p, p) = t(P) - t/!(P - qp)). (1.27)

The truth-telling requirement in particular implies that for any pair of

values Pand P' in [~, PJ,
t(P) - t/!(P - C(p)) ¿ t(fJ') - t/!(fJ - C(P')), (1.28)

t(P') - t/!(P' - qp')) ¿ t(P) - t/!(fJ' - C(p)). (l.29)

Adding up (1.28) and (1.29) gives
t/!(P' - qp)) - t/!(P - C(p)) ¿ t/!(fJ' - C(P')) - t/!(P - C(P')), (l.30)

or
p· Jc¡p·¡
fp C(p)
t/¡"(x - y)dxdy ¿ O. (1.31)

Therefore, if P' > p, C(P') ¿ C(p). Incentive compatibility thus implies

that C( ·) is a nondecreasing function. Hence C( ·) is differentiable almost
everywhere. Actually we will focus on a smaller class of functions, the
class of piecewise differentiable functions in order to use optimal control
theory (a piecewise differentiable function admits a continuous derivative
except at a finite number of points, and when the derivative does not exist,
76 Chapter 1

where {30 > ~. h >O, k > O (see figure l.7b). 13 The inverse hazard rate
F/f = ({30 - {3)/k is decreasing, and it decreases quickly for k small. Thus,
for k sufficiently small, 14 the solution in eq uation ( 1.44) satisfies e({J) > 1,
or, equivalently, C({J) < O on ( -oo, p]. The solution <loes not satisfy the
incentive constraint C(p) ~ O. -
We conclude that there is a conflict between incentive compatibility-
the realized cost must increase with the firm's type-and optimality-
the realized cost ought to decrease with the firm's type-over the range
( - oo, p]. A proper resolution of this conflict follows the lines of the study
of bunching in appendix A1.5 of this chapter, but it is easy to guess its
outcome. The constant cost allocation, C({J) = O on ( - oo, p], with
p > p, is the policy that approximates the optima! solution best while
still being implementable. Therefore there is bunching of ali types in
( -oo, PJ at the cost leve! of type p. This (constrained) optimum can be
implemented by a compensation cap at the leve! t(C(p)) as in figure
l.7a.
p
The previous analysis for f3 ~ remains unchanged. A cost ceiling is
rationalized by our analysis of the shutdown option. For an efficiency
parameter above sorne cutoff value {3*, it is not worth letting the firm
produce. 1 5

1.5 The Main Economic Conclusions

We now collect sorne main results and show how a careful reading of these
results allows us to anticípate sorne latter themes of this book.
Result 1.1 Asymmetric information allows the regulated firm to enjoy a
rent.
Result 1.2 Asymmetric information reduces the power of the incentive
schemes (effort decreases).
It is interesting to note that the power of procurement contracts is quite
sensitive to uncertainty. As noted in section 2 of the introductory chapter,
fixed-price contracts tend to be used for either production contracts or
low-tech projects, while cost-plus contracts are more popular for devel-
opment contracts or high-tech projects. Thus contracts are more low-
powered when technologies are not standard. An alternative explanation
for this fact is that the firms are risk averse and seek insurance when

13. Note that for given ({J0 , k), F({J) = l1({J0 - /J)-• can be made as small as desired by choos-
ing h small. The following reasoñlng does not- rely on F({J ) being small but rather hinges on
the increasing hazard rate property below p. -
14. When ¡/J(e) = e2/2, k < J../(1 + J..) yields °i({J) > l.
15. Consider, for instance, the distribution in fi gure l. 7b. Suppose that production is very
valuable so that type p should not be shut down, and that the density is rapidly decreasing
beyond p. Then P* lies jusi beyond p.
77 Cost-Reimbursement Rules

forecast errors are substantial. Since the magnitudes of ex ante informa-

tional asymmetries and ex post forecast errors are likely to be highly
correlated, such practice does not distinguish between the screening and
insurance explanations. But the importance of informational asymmetries
and rent extraction concerns suggests that part of the explanation is the
difficulty in extracting rents when technologies are not standard.
Results 1.1 and 1.2 compare the asymmetric and symmetric informa-
tion situations; they were proved in sections 1.3 and 1.4. More generally
we would want to compare different degrees of asymmetric information.
Appendix Al.6 compares the expected slopes of incentive schemes for two
structures of information that are comparable in the sense of Blackwell
(1951). Another kind of comparison of distributions will prove more rele-
vant for the purpose of this book:
Definition 1.1
i. Two-type case. The distribution (v, 1 - V) is more favorable than distri-
bution (v, 1 - v) if v ;:::>:: v.
ii. Continuum case. The distribution G on [/3, PJ is more favorable than
the distribution F on the same interval if
G(/3) ;::::: F(/3) for ali p (first-order stochastic dominance)
and

g(p) < f(/3)

for ali p (hazard rate dominance).
G(/3) - F(p)
In other words, one distribution is more favorable than another if it puts
more weight on more efficient types. In the two-type case this simply
means that the probability of type f3 is higher. We require the analogous
property in the continuum case (first-order stochastic dominance) and
impose the regularity condition that G has a lower hazard rate. Returning
to the interpretation of the hazard rate, the conditional probability that
there is no more improvement relative to the basic technology when there
are already [p - PJ improvements is smaller for G than for F. Properties
of part ii are satisfied, for instance, for G uniform on [/3, iJJ and F uniform
on [/3, p], where iJ ~ p. More generally they are satisfied by any two
cumitlative distribution functions G and F such that G = M(F), where M
is increasing and conca ve. 16

16. As noted by Maskin and Riley (1986). First, M concave, M(O) =O, and M (l) = 1 [be-
cause G(~) = F@ =O and G(PJ = F(iJ) = 1] imply that G(/J) ~ F(/J) for ali /J. Second,

!_ _ '!_a!_(~)a[M - FM']f,
F G d/J G '
where a means "proportional to." But (M - FM')(~) =O, and (M - FM')' = -FM''f~ O.
78 Chapter 1

Results 1.3 and 1.4 are similar to results 1.1 and 1.2 but compare distri-
butions that are more or less favorable.
Result 1.3 A firm with type f3 enjoys a higher rent when the regulator's
probability distribution is less favorable.
Proof
i. For the two-type case, let ó/i(v) denote the (reduced-form) rent of type ~
when the regulator's beliefs are v. Consider two probabilities v and v such
that v > v. Suppose first that the regulator keeps type Pfor beliefs v and
therefore for probability v. Equation (1.23) implies that e(V) < e(v) because
<I> is convex. Since ó/i(v) = <l>(e(v)) and <!>( ·) is increasing, ó/i(v) > ó/i(V).
When v is such that the regulator shuts down type fj, then ó/i(V) = O, and
the result holds automatically.
ii. For the continuum case, let ó/i(f3, F) denote type f3's rent when the
regulator's beliefs are F, and similarly for distribution G. With notation as
before, equation (1.44) implies that e* (/3, F) ~ e* (/3, G) if the hazard rate
condition holds. We leave it to the reader to check that the cutoff points
satisfy /3*(F) ~ /3*(G) from equation (1.67). lf f3::;; /3*(G), then
p*(G)
ó/i(f3, G) =
f
P

p*(F)
1jt'(e*(p, G))dP

::;;
J
P 1jt'(e*(p, F))dp = ó/i(/3, F).

If f3 > /3*(G), then ó/i(f3, G) = O, and the result automatically holds. •

Result 1.4
i. The effort of type f3 is lower when the regulator's probability distribu-
tion is more favorable. (Furthermore any type f3 > ~ will eventually be
shut off if the probability distribution becomes favorable enough.)
ii. lf F and G are continuous distributions satisfying assumption 1.2, and
if 1//'(') is constant, the expected slope of the incentive scheme is lower for
the more favorable distribution provided that the firm is indispensable
(i.e., the cutoff must be p for both distributions). When the firm is not
indispensable, the cutoff type is smaller for the more favorable distribu-
tion; this effect increases the average slope of the incentive scheme for the
more favorable distribution relative to that of the less favorable one and
makes the comparison of the average slopes ambiguous.
Part i does not imply that an outside observer will observe on average
more powerful incentive schemes when the distribution is less favorable
because the distribution puts more weight on inefficient types, who choose
low-powered incentives, as we have seen. Part ii of the result is an attempt
to say something about the expected slope.
 79 Cost-Reimbursement Rules

Proof
i. The proof follows the same lines as that of result 1.3.
ii. Since the slope of the incentive scheme is equal to 1//(e), equation (1.44)
implies that
A. fr<F> F(P}t//'(e*({J, F))d{J
EFb = 1 - 1 + A. - F({J*(F)) '

and similarly for distribution G. Thus, for 1//'(-) constant, EFb ~ EGb if
and only if

Jr<FJF({J)d{J w(G) G({J)d{J

- > - .
F(P*(F)) - G(p*(G))

Consider a family of log-concave distributions H( ·, p) with H(p, O) =

F({J), H({J, 1) = G(/J) for ali p, o(h/H)/8{3 ~O, 8H/8p ~ O, and o(h/H)/op ~
O (where h is the density of H). We require that HP be strictly positive
for a set of {J's of positive measure. The derivative of [H°<H>H(p)dp]/
H(P*(H)) with respect top is equal to -

1 1 d{J*
H 2A + H2 dp B,

where
{J.(H) JfJ•(H)
A =H({J*(H)) J fl_ Hp(/J)d{J - Hp(/J* (H)) fl_ H({J)d{J

and
p•(H )
B = H 2 (/J*(H)) - h(P*(H))
J
fl_ H({J)d{J.

That B is positive results from Prekova's (1973) theorem: A sufficient

condition for a strictly monotonic function on an interval [p,p] taking
value O at either p or p to be log concave on this interval is that its
derivative is log concave. Here B ~ o is implied by H(P)dp log concave H
in p. From Prekova's theorem this in turn is implied by H( ·) log concave,
which is assumption 1.2.
We also noted in the proof of result 1.3 that d{J*/ dp ~O. Hence it re-
mains to be shown that A ~ O. Let

A({J) ::: H({J) f: HP - Hp(/J) f: H.

Clearly A(/3) =O, and A(,8) > O since HP ~ O, HP > O on a set of positive
measure añd HP(,8) = O. The derivative of A is

dA
d{J = h JP
fl_ Hp - hp
JP
fl_ H.

j
80 Chapter 1

We know that HP ~ O. Hence, if hP ~O, dA/df3 ~ O. If hp(/3) ~ O and

A(/3) =O,

~; = hp (f: Hp)[h: -f/ZJ

~ hp (f: Hp)[Zp -!IZJ =o,
using a(h/H)/8p ~O. Hence dA/dfJ ~O whenever A(/3) =O, and since
A(iJ) > O, A(fJ) ~O for all {3.
The proof of part ii has revealed three effects: First, a more favorable
distribution lowers the cutoff type and therefore raises the average slope of
the incentive scheme (less efficient types have lower slopes). Second, the
more favorable distribution puts more weight on more efficient types,
resulting again in higher slopes. Third, the regulator is more eager to
extract rents because the hazard rate is smaller; this reduces the slope of
the incentive scheme for a given {3. The third effect dominates the second,
as shown by the property A ~ O. •
Results 1.1 through 1.4 suggest a number of insights for further analysis:
Result 1.1 shows that the firm is better off under asymmetric informa-
tion. It will therefore want to keep secret information about its technol-
ogy. We will make much use of this idea when providing agency-theoretic
foundations for the phenomenon of regulatory capture in chapter 11. The
firm will benefit from the retention of information that would allow the
extraction of its rent.
Result 1.2 shows that the concern for rent extraction reduces the power
of incentive schemes and moves them toward cost-plus contract. An im-
portant theme of this book is the determination of other factors (risk
aversion, quality concerns, competition, dynamics, auditing, politics, etc.)
that increase or decrease the power of incentive schemes.
Result 1.3 is the foundation for the ratchet effect studied in part IV of
this book. An efficient type has an incentive to convince the regulator that
it is inefficient. As we will see, this implies that it is more difficult to elicit
the firm's information in a multiperiod context than in a single-period one.
Result 1.5 below refines result 1.3 by comparing the relative gain of two
types of convincing the regulator that the distribution is less favorable.
Result 1.3 also provides a foundation for the phenomenon of regulatory
capture studied in part V of the book. Suppose that the prior distribution
on [{3, PJ is F( · ). The regulator obtains sorne signa! p, and signals are
ordered in the sense that a higher p yields a more favorable posterior
distribution H(-, p). The firm would like to induce the regulator to an-
nounce a low signa! in arder to enjoy a higher rent.

\
81 Cost-Reimbursement Rules

Result 1.5 A type gains more from the regulator's distribution being less
favorable than a less efficient type.
Proof Let us prove a stronger result. Suppose that the firm <loes not
necessarily know its type. It simply knows from which distribution F or G
it will be drawn, where G is more favorable than F.
The gain A 1 for a firm with "type" F (i.e., knowing Pwill be drawn from
F) from having the regulator believe that the distribution is F rather than
G, where Gis more favorable than F, is
P*<F> íP*<G>
A 1 = fl.
J
il/i(p, F)dF(p) - Jfl. il/i(p, G)dF(p).

Similarly the gain A2 for a firm with type G from having the regulator
believe that the distribution is F rather than Gis
P*<FJ JP *<G>
A2 =
f fl. il/i(p, F)dG(p) - fl. il/i(p, G)dG(p).

Integrating by parts yields

P*<FJ
A2 - A1 =
f fl.

P*<G>
t//(e1(P))[G(p) - F(P)JdP

- fl. tf/(et,(p)) [G(p) - F(p)]dp.

J
Last, G ¿ F , /3*(F) ¿ /3*(G), and e¡(·) ¿ ea(") imply that A2 ¿ A1 . The
proof is similar in the two-type case. •
Result 1.5 implies that in a multiperiod context in which the firm's type
is positively correlated over time, an efficient type has more incentive than
an inefficient type to convince the regulator that it is inefficient. This indi-
cates that it will be quite difficult to learn the type of an inefficient firm.
Result 1.6 An increase in the gross surplus S raises the firm's rent.
Result 1.6 follows directly from section 1.3 and 1.4, where we showed
that the cutoff type (weakly) increases with S and that the rent of a given
type increases with the cutoff type. In chapter 2 we will show more gener-
ally that an increase in demand raises the firm's rent. This suggests that the
firm <loes not like to face product market competition. This idea is central
to our study of access pricing (chapter 5), cartelization (chapter 13), and
favoritism (chapter 14). 17
Severa} regulatory issues are related to the firm's engaging in multiple
activities. Besides exerting effort, it may invest or increase the quality of its

17. In chapter 6 we will encounter the bizarre case of competition by a substitute product
that raises the firm's demand. But there is no contradiction with the general rule because we
will show then that competition also increases the firm's rent.
82 Chapter 1

product. These activities interact with efiort because they jointly deter-
mine cost. Let us for the moment index the disutility of efiort function
by a parameter (, which is a proxy for an activity: ij¡(e, (). We assume
that fJij¡/fJ( >O (the activity ( increases the disutility of efiort) and that
fJ 2 ij¡/fJefJ( >O (the activity ( increases the marginal disutility of effort).
That is, e and ( are substitute activities.

Result 1.7 If ,1. is small, if there is little uncertainty, or if fJ 3 ij¡/fJ 2 efJ( is

nonnegative, an increase in the intensity ( of the substitute activity reduces
the power of optimal incentive schemes: fJe* (/3}/fJ( < O.

The assumptions fJij¡/fJ( > O, fJ 2 ij¡/fJefJ( > O, and fJ 3 ij¡/fJ 2 efJ( ~ O are quite
easy to interpret when the substitute activity (e.g., investment or increase
in quality) increases cost in an additive way: C = ({3 - e)+ ( and the dis-
utility of effort is ij¡( · ). Substituting e = f3 - C + (, the disutility of effort
becomes 1/1(/3 - C + (). The assumptions then boíl down to 1/1' > O, 1/1 > O,
11

"'111 ~ o.
Result 1.7 is stated in terms of effort being crowded out by the substitute
activity. Another way of interpreting the result is that low-powered incen-
tive schemes are needed to encourage the production of the substitute
activity. We will rnake use of this idea in models in which the firrn chooses
its quality (chapter 4) and invest in long-term capital (chapter 8).

1.6 Implementation: Relevance and Informational Requirements of Menus

In this section we discuss two issues concerning the application of the

optima! incentive scheme: Is the idea of menus incongruous? What infor-
mation do they require? We saw that in the presence of informational
asyrnmetries, the regulator optirnally offers a menu of contracts to the
firm. It can be argued that we do not observe regulators offering menus of
contracts in practice. We can respond to this in three ways. First, we might
observe only the final contract signed by the firm, and not the bargaining
process that gives rise to this contract. When bargaining over cost sharing
and pricing, regulators are likely to screen the firm's information about
technology. Second, there exist examples of explicit menus of managerial
incentive schemes in corporations. For instance, many managers are given
the choice of cashing their bonuses or stock options or transforrning them
into stocks or stock options. They thus face a menu. The option of cashing
in on rewards for past performance can be viewed as a low-powered incen-
tive scheme in which the manager decides not to be rewarded according to
performance in the future (at Ieast not beyond the extent defined by bis
or her other holdings of stocks and stock options). The option of buy-
ing (further) stocks or stock options can be viewed as choosing a high-
powered incentive scheme. Presumably the second option has a higher