Monitoring of Performance in Organizational Contracting: The Case of Defense Procurement

This paper presents an agency theoretic analysis of defense procurement contracts. In the model presented the government designs optimal linear compensation contracts for a risk-averse supplier in the presence of moral hazard, private information, and imperfect monitoring. Optimal contracts in this setting generally invoice deviations form first-best risk sharing. The direction of the deviation depends on the relative severity of the moral hazard and private information problems and on the precision of the monitor. The supplier’s effort decision is analyzed and, in contrast to the usual result in the moral hazard literature, the government may in some cases prefer that the supplier exert less effort given the optimal compensation contract. The paper also studies the choice of a monitoring technology in terms of the precision of the monitor and the categories of costs covered by the monitor. Under certain circumstances it is shown that the government may want to monitor only a fraction of the capital costs of a procurement project even though all capital costs could be costlessly monitored.