Calculate the contractors profit-maximizing choice of effort

Reference no: EM13190688

A contractor has been chosen to perform a government project. To avert the moral-hazard risk that the contractor will behave inefficiently, government is considering how to use contractual incentives to avoid cost overruns. Government has a target price for the project of W=$10mm but realizes the maximum cost could be C*=$20mm. The contractor would expend effort (E) to avoid inefficient practices. The cost of effort is given by E^2/2D, where D= 2mm. Government is considering a cost-sharing contract which requires the contractor pay v=50% of any cost-overruns, a fixed price contract (v=0), and a cost-plus contract (v=1).

Calculate the contractor's profit-maximizing choice of effort (E) to improve efficiency under each form of contract.

Reference no: EM13190688

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