The economics of governance is an effort to implement the “study of good order and workable arrangements,” where good order includes both spontaneous order in the market, which is a venerated tradition in economics

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When the quality of a good is at the discretion of the seller, how can buyers assure that the seller provides the mutually efficient level of quality? Contracts that provide a bonus to the seller if the quality is acceptable, or impose a penalty on the seller if quality is unacceptable, can in theory provide efficient incentives. But how are such contracts enforced? While the courts can be used, doing so involves high real costs. Informal enforcement, involving a loss of reputation and future access to the market for any party that defaults on a contract, may often be a better alternative. This paper explores the use of both formal and informal enforcement mechanisms, provides a rationale for a variety of observed market mechanisms, and then generates a number of testable hypotheses.

Procurement contracts are often renegotiated because of changes that are required after their execution. Using highway paving contracts we show that renegotiation imposes significant adaptation costs. Reduced form regressions suggest that bidders respond strategically to contractual incompleteness and that adaptation costs are an important determinant of their bids. A structural empirical model compares adaptation costs to bidder markups and shows that adaptation costs account for 8-14 percent of the winning bid. Markups from private information and market power, the focus of much of the auctions literature, are much smaller by comparison. Implications for government procurement are discussed.

Local governments can provide services with their own employees or by contracting with private or public sector providers. We develop a model of this “make-or-buy” choice that highlights the trade-off between productive efficiency and the costs of con-tract administration. We construct a dataset of service provision choices by U.S. cities and identify a range of service and city characteristics as significant determinants of contracting decisions. Our analysis suggests an important role for economic efficiency concerns, as well as politics, in contracting for government services. JEL codes: D23, D73, H11, L33. ∗We are grateful to city managers Frank Benest, David Boesch, Kevin Duggan and Dave Knapp for helping

We propose a distinction between active waste and passive waste as determinants of the cost of public services. Active waste entails utility for the public decision maker (as in the case of bribery) whereas passive waste does not (as in the case of inefficiency due to red tape). To assess the empirical relevance of both forms of waste, we analyze purchases of standardized goods by Italian public bodies and exploit a policy experiment associated with a national procurement agency. A revealed preference argument implies that if public bodies with higher costs are more likely to buy from the procurement agency rather than from traditional suppliers, cost differences are more likely to be due to passive waste. We find that: (i) Some public bodies pay systematically more than others for observationally equivalent goods and such price differences are sizeable; (ii) Differences are correlated with governance structure: the central administration pays at least 22 % more than semi-autonomous agencies (local government is at an intermediate level); (iii) The variation in prices across public bodies is principally due to variation in passive rather than active waste; (iv) Passive waste accounts for 83 % of total estimated waste.

Mechanism design theory rests critically on the assumption that the principal can fully commit to the workings of the mechanism (or contract). We study a model of optimal contracting between an uninformed principal and informed agent where the principal’s commitment power is imperfect. Although the standard revelation principle is not valid without full commitment, we derive a limited version that nevertheless allows us to characterize the set of incentive feasible contracts. We show that while full revelation is feasible, it is never optimal. The optimal contract is “bang-bang” — in one region of the state space, full alignment takes place, in the other, no alignment takes place. We then compare these contracts to those in which the principal has full commitment power as well as to several “informal”institutional arrangements. JEL Classi…cation D23, D82. 1

Abstract Performance-based contracting is reshaping service support supply chains in capital intensive industries such as aerospace and defense. Known as "power by the hour" in the private sector and as performance-based logistics (PBL) in defense contracting, it aims to replace traditionally used fixed-price and cost-plus contracts in order to improve product availability and reduce the cost of ownership by tying a supplier's compensation to the output value of the product generated by the To analyze implications of performance-based relationships, we introduce a multitask principalagent model to support resource allocation and use it to analyze commonly observed contracts. In our model the prime (principal) faces a product availability requirement dictated by its customer for the "uptime" of the end product. The prime then offers contracts contingent on availability to n suppliers (agents) of the key subsystems used in the product, who in turn exert cost reduction efforts and set spare parts inventory investment levels. We show that the first-best solution can be achieved if channel members are risk-neutral. When channel members are risk-averse, we find that the second-best contract combines a fixed payment, a cost-sharing incentive and a performance incentive. Furthermore, we show how these contracts evolve over the product deployment life cycle as product use and support cost risks change. We show, in particular, that when the prime is less (more) risk-averse than the suppliers, the performance incentive increases (decreases) while the cost sharing incentive decreases (increases) with time. Finally, we illustrate the application of our model to a problem based on aircraft maintenance data and show how the allocation of performance requirements and contractual terms change under various environmental assumptions. * The authors are grateful to the seminar participants at the Wharton School, Cornell University, the University of Texas at Dallas and the University of Washington in Seattle for helpful discussions. The authors would also like to acknowledge input from L. Gill, S. Gutierrez, M. Lebeau and M. Mendoza, who provided valuable information concerning current practices. Finally, the authors are grateful for the assistance of Ashish Achlerkar of MCA Solutions, who provided valuable assistance in testing the model and providing access to a real-world data set.

In many procurement auctions, the bidders ’ unobserved costs depend both on a common shock and on idiosyncratic private information. Assuming a multiplicative structure, I derive sufficient conditions under which the model is identified and propose a nonparametric estimation procedure which results in uniformly consistent estimators of the cost components ’ distributions. The estimation procedure is applied to data from Michigan highway procurement auctions. Private information is estimated to account for 34 % of the variation in bidders ’ costs. It is shown that accounting for unobserved auction heterogeneity has important implications for the evaluation of the distribution of rents, efficiency, and optimal auction design.

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