Public Contracting : Incentive Theory

Incentive theory addresses how asymmetric information between actors distorts economic relationships and creates challenges for contract design, particularly in public service provision. When a government outsources public services to private firms, it often lacks full information about each firm's capabilities or efforts. Two main issues emerge: adverse selection, which occurs before the contract is signed, and moral hazard, which arises afterward. Adverse selection means the government may select the wrong firm because it cannot observe the firm’s true type or efficiency. Moral hazard implies the firm, once contracted, might not exert sufficient effort since its actions are unobservable or costly to monitor.

In response, incentive theory proposes designing contracts that align private behavior with public goals. This includes offering menus of contracts that lead firms to self-select based on their type—efficient firms will choose contracts that reward performance, revealing their private information. However, this introduces a trade-off between rent extraction (capturing the firm’s surplus) and efficiency (encouraging cost reduction and innovation).

Two polar regulatory models illustrate this: price cap regulation, where the firm’s revenues are fixed and not tied to actual costs, offers strong cost-cutting incentives but risks quality degradation and excess profit. Cost-plus regulation, in contrast, reimburses actual costs plus a margin, safeguarding quality and reducing excess profit, but fails to motivate efficiency. Neither model is perfect: price caps prioritize incentives over information, while cost-plus secures information at the expense of effort. The balance between them defines the core dilemma of regulatory contract design.

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