An Incentive Scheme Design for Long-Term Contractor Cooperation

In bid invitation, the project owner is interested in deploying the contract mechanism that will secure reliable service at the cheapest cost and best quality. On the other hand, the contractor bidding for the project is interested in winning the contract at a price that assures him a reasonable profit margin. This paper develops a game-theoretic model which studies the contract design problem of the project owner when it faces with a contractor whose quality of service and the cost of providing the service are private information to the owner. We apply the Revelation Principle to our analysis and characterize the optimal contract. The result shows that the project bid works best when offered to the contractor with high capability includes either a penalty scheme or a gain-sharing scheme, and the contract offered to the contractor with low capability includes only premium. Furthermore, the more attractive the gain-sharing scheme, or alternatively, the more severe the penalty is, the less the initial remuneration is and vice versa. Finally, the paper proves that for the high and media capability contractors, the proposed optimal contract is independent of the ex-ante beliefs which the owner has on the capability and the cost of the contractor.