Contracting for Complex Products

Abstract

A fundamental source of contracting failure is product uncertainty. When the product's cost, quality, and quantity cannot be easily defined, buyers and sellers are unable to clearly and completely define exchange terms. The risk is that the buyer is the only purchaser of this “complex product,” and once the contract is let, the vendor is the only supplier. The consequence is a collective action problem in which each party has incentives to exploit contract ambiguities for their own gain at the other's expense. We lay out the theoretical case for how complex contracting risks collective action problems. We then illustrate the theory's analytic value with the case of the Coast Guard's controversial Deepwater project, a major acquisition program to upgrade and integrate its fleet of air and sea assets. Through this case, we show how managing the state of agents requires understanding how different principal-agent relations’ work.

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