Efficient Incentive Contracts

A so-called "incentive contract" is a linear payment schedule, where the buyer pays a fixed fee plus some proportion of audited project cost. That remaining proportion of project cost borne by the seller is called the "sharing ratio." A higher sharing ratio creates more incentive to reduce costs. But it also makes the agent bear more cost uncertainty, requiring as compensation a greater fixed fee. The tradeoff between incentives and risk in determining the sharing ratio of an efficient contract is the central theme of the present paper. A formula is derived that shows how the optimal sharing ratio depends on such features as uncertainty, risk aversion, and the contractor's ability to control costs. Some numerical examples are calculated from the area of defense contracting.