The RAND Corporation
The Efficiency of Incomplete Contracts: An Empirical Analysis of Air Force Engine
Procurement
Author(s): Keith J. Crocker and Kenneth J. Reynolds
Reviewed work(s):
Source: The RAND Journal of Economics, Vol. 24, No. 1 (Spring, 1993), pp. 126-146
Published by: Blackwell Publishing on behalf of The RAND Corporation
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RAND Journal of Economics
Vol. 24, No. 1, Spring 1993
The efficiency of incomplete contracts:an empirical
analysis of air force engine procurement
Keith J. Crocker*
and
Kenneth J. Reynolds*
*
This article examines the incentivesfor contractualparties to design agreements that are left
intentionallyincompletewith regardtofuture duties or contingencies.More complete contracts
mitigate ex post opportunism and the associated distortions in unobservableinvestment, but
at the cost of additional resources expended in ex ante design. The optimal degree of contractual incompleteness involves a tradeoff between these opposingforces, the magnitudes of
which may be predicted based on observable characteristics of the transactors and of the
exchange environment. The resulting hypotheses are tested using panel data on the pricing
procedures used in Air Force engine procurement contracts. We conclude that the degree of
contractual completeness chosen in practice reflects a desire by the parties to minimize the
economic costs associated with contractual exchange.
1. Introduction
* This article examines the design of optimally incomplete exchange agreements, where
contractingparties intentionally leave unspecifiedtheir duties in certain contingencies. When
contemplating exchange in a long-term relationship, agents are confronted with a tradeoff
between the ex ante costs of craftingmore complete agreementsand the ex post inefficiencies
associated with less exhaustive arrangements. Our central premise is that the relative magnitudes of these costs are systematically related to the nature of the product to be exchanged
and to the characteristics of the parties involved, leading to testable implications about the
efficient level of contractual incompleteness. We examine panel data consisting of Air Force
engine procurement contracts, and find strong support for the hypothesis that the degree
* Pennsylvania State University.
* * Office of the Assistant Secretaryof Defense, Program Analysis and Evaluation.
We appreciate the constructive criticism provided by Michael R. Baye, Timothy F. Bresnahan, Craig E.
College, William E. Kovacic, Scott E. Masten, David L. McNicol, Terry L. Raney, Randal R. Rucker, and Larry
Samuelson. This article has also benefited greatly from the suggestions of two anonymous referees. A particular
expression of gratitude is due, without implication, to Mark J. Roberts for his assistance on the econometric issues
addressed herein. A preliminary draft of this article was presented at the RAND/OSD/PA&E Workshop in the
Economics of Defense Procurement, October 1989. The views, opinions and/or findings contained in this article
are those of the authors, and should not be construed as the official position or policy of the Department of Defense.
126
CROCKER AND REYNOLDS
/
127
of contractual completeness actually chosen by the parties in practice reflects a desire to
minimize the economic costs of contractual exchange.
The potentially deleterious effects of contractual incompleteness have been recognized
for some time.' The approachadopted by Williamson ( 1985), Goldberg ( 1985), and Masten
( 1988) emphasizes the role of ex post opportunism in the dissipation of the gains from
trade. These authors argue that contracts set in uncertain or complex environments are
necessarily incomplete, thereby permitting parties to engage in economically costly efforts
to redistributethe surplusas uncovered contingencies arise. An alternativeview is enunciated
by Tirole ( 1986) and Hart and Moore ( 1988), who consider the incentive effects of ex post
bargaining on the level of ex ante investment. Contracts are assumed to be incomplete in
the sense that agents are unable to commit to a division of the contractual surplus before
making their unobservable investment decisions. Although the bargaining process is not
resource consuming per se, the prospect of such a redistribution distorts agents' incentives
to invest and diminishes the gains from trade. More recently, Rogerson ( 1990) demonstrates
the existence of a more general allocation mechanism that achieves first-best levels of investment, indicating that inability to precommit to ex post surplus division is a source of
inefficiency only if there are impediments to the implementation of complex allocation rules.2
Were contracting costless, it would be possible in principle to design arrangements
complete enough to circumscribe all surplus-eroding redistributive tactics and intricate
enough to mitigate investment distortions. In practice, however, the costs of identifying
contingenciesand devising responses increase rapidlyin complex or uncertain environments,
placing economic limits on the ability of agents to draft and implement elaboratecontractual
agreements. When designing a contract, the parties may mitigate ex post opportunism and
investment distortions by the use of more complete agreements, but at the cost of increased
resources dedicated to crafting the document a priori. As a consequence, environmental
characteristicsthat generate increased contracting costs should result in efficient contracts
being less complete, whereas conditions that exacerbatethe potential for ex post inefficiencies
should lead to more exhaustive agreements.
The article proceeds as follows. Section 2 presents the economic tradeoffs inherent in
contract design, where the costs arising from incomplete agreements are consistent with
either ex ante investment distortions or costly bargaining ex post. The comparative statics
analysis provides hypotheses on the effect of environmental characteristics on the efficient
level of contractual completeness; these hypotheses form the basis for the empirical work
that follows. Section 3 describes the contractual types permitted in military procurement,
and Section 4 describes the unique panel data used in the empirical section. Section 5
contains the empirical results, and a final section provides concluding remarks.
' Contractual incompleteness has also played an implicit, yet important, role in recent empirical studies of
procurement and long-term contracting. The inability to observe and contract upon actual innovative output
provides the motivation for Rogerson's ( 1989) study of procurement, where large profits obtained in production
serve as an inducement for firms to invest in innovative activities a priori. The work on contract length by Joskow
(1987) and Crocker and Masten (1988) examines contractual incompleteness, but in an intertemporal sense. In
each case, the optimal duration of agreements depends upon the tradeoff between the ex ante cost of extending
contractlengthand the expost economic losses associatedwith unconstrainedbargaining.The potential for reasonably
complete contracts to mitigate such ex post opportunism is convincingly illustrated in Joskow's ( 1990) study of
long-termcoal contracts,which finds contractualrelationshipsto remain largelyin place despite substantialdivergence
betweencontractuallydeterminedpricesand the spot marketalternative.On the other hand, less complete agreements
may permit more flexible adaptation to changing economic circumstances, as demonstrated in the natural gas
market by Crocker and Masten ( 1991 ).
2 In the course of the discussion we shall use the words "complete" and "complex" interchangeably.Complete
contracts may be complex, and the inability to implement complex agreements leads to contractual incompleteness.
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THE RAND JOURNAL OF ECONOMICS
2. Economic
issues
in contract design
* When contemplating an exchange to be governed by a long-term contract, the parties
to the agreement must consider how explicitly they want their future duties to be enumerated.3 We formally represent this decision on the degree of contractual completeness as the
selection of a parameter p E [0, 1] which denotes the probability that a contingency not
expressly covered by the agreement may arise. If all potential contingencies are covered by
a totally complete contract (p = 0), then there will be no opportunities for ex post bargaining.
Alternatively, a totally incomplete contract (p = 1) places no strictures at all on the terms
under which subsequent trade may be effected. Intermediate degrees of contractual completeness specify duties for some contingencies, perhaps the more easily anticipated ones,
leaving the other possibilities to future resolution as events unfold. The degree of specificity
actually chosen by the parties in a particular contractual setting should reflect an efficient
tradeoff between the expected costs and benefits of contractual incompleteness.
The primary costs associated with the drafting of more complete agreements are the
difficulties of identifying feasible contingencies and negotiating mutually acceptable responses. While this may be fairly straightforwardin simple environments with proximate
dates of contract execution, the task becomes more daunting when the possibilities are more
numerous and the time of performance remote. Moreover, holding environmental complexity constant, the parties are likely to face increasing costs of crafting more complete
agreements as the additional contingencies become more hypothetical. Accordingly, we
assume that the marginal cost of implementing more precise agreements is increasing in
the degree of contractual completeness
w.
environmental
uncertainty,
(I - p), as depicted
in Figure
1, and in the level of
FIGURE1
MC (0)
MB (L)
0
(1 - P*)
Contractual
completeness
3The motivation for long-term contracting as an alternative to spot market exchange has been examined in
detail by Williamson ( 1979, 1985), Klein, Crawford,and Alchian ( 1978), Goldberg ( 1976), Goldberg and Erickson
( 1987), and in the empirical contracting literaturementioned previously. In the discussion that follows, we assume
that a contract is the preferredmode of exchange, and our concern will be with the degreeof contractualcompleteness
the parties select.
CROCKER AND REYNOLDS
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129
The advantage of a tighter agreement is that it reduces a party's ability to engage in
efforts designed to effect privately favorable distributions of the ex post contractual surplus.
Such restrictions benefit the parties when the available redistributive tactics consume resources.4 As an illustration, consider the case of a contingency not expressly covered by the
contract. The partiesincur the resourcecost of bargainingdenoted by the increasingfunction
B(L), where L indicates the likelihood of opportunistic (redistributive) activities. In this
case, the expected bargaining costs would be pB(L), and the marginal benefit of increased
completeness, B(L), is the reduction in the resource costs associated with bargaining.
In addition to the direct costs of redistributiveactivities, the possibility of unconstrained
renegotiation raised by contractual incompleteness generates potential inefficiencies by discouraging ex ante investment. This problem arises because of the parties' inability to precommit to an enforceable division of the contractual surplus in all future states. Investors
recognize that part of the benefits from their efforts may accrue, as a consequence of future
redistributiveactivities, to the other party. The marginal benefit of a more complete contract
in this scenario is a reduction in the magnitude of the investment externality, which is also
positively related to the likelihood of opportunistic behavior, L. Under the assumption that
investment disincentives increase in severity as contracts become less complete, the marginal
benefit from contractual completeness is a decreasing function, as depicted in Figure 1.
At the time of contractual negotiations, agents have expectations about c and L, and
they face a tradeoffbetween the costs and benefits of contractualincompleteness. The efficient
level of contractual incompleteness equates the marginal costs and marginal benefits of
contracting, which depend on the degree of environmental complexity (co) and the agents'
beliefs about the likelihood of ex post opportunism (L). On the one hand, variables leading
to increased environmental complexity should shift the marginal cost of contracting curve
upward, resulting in less exhaustive agreements. On the other hand, variables increasing
the likelihood of opportunistic behavior shift the marginal benefit curve upward, making
more structuredagreements attractive.5These hypotheses may be tested with a panel dataset
of contracts by estimating the reduced-form relationship
Pi
= Pi(1j1,
Lit)
+ (it,
(1)
wherethe i and t subscriptsindicate firm and time observations,respectively,and it represents
an error term. This specification permits the time-invariant function Pi (*, *) to be firmspecific, so that we may use a time series of contractual observations across a cross section
of firms to identify the effect on contractual completeness of the exogenous parameters W
and L. The particulars of our data and the econometric specification will be considered in
more detail below. First, however, we turn to a discussion of the regulations governing the
choice of contractual completeness in defense contracting.
3. Contracting
in defense
procurement
* The degreeof environmental complexity and the likelihood of opportunism come directly
to bear in the design of military procurement contracts. By its nature, defense acquisition
involves substantial recurringinvestment in relationship-specificassets by a relatively small
4Muris ( 1981) and Goetz and Scott ( 1981 ) provide extensive discussion on the forms taken by and the costs
associatedwith commonly used opportunistic tactics. See also Crockerand Masten ( 1991 ) for additional discussion
and sources.
5 These issues are particularly relevant in view of Rogerson's ( 1990) recent results, which demonstrate that
sufficientlycomplex contractingmechanisms may mitigatethe ex ante investment disincentivescaused by contractual
incompleteness. If the implementation of such incentive schemes entails resource costs that are positively related
to the uncertainty or complexity of the exchange environment, then contracting parties may be willing to accept
some contractual incompleteness and, hence, investment inefficiency at the margin to reduce contracting costs.
The degree of incompleteness actually chosen should reflect the economic tradeoff discussed above.
130
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THE RAND JOURNAL
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group of highly specialized defense contractors. Consequently, in major weapons systems
the government has few (if any) alternative suppliers ex post, owing to the extensive lead
time and costs required for development and production. The administrative burden associated with the selection, governance, and compensation of numerous private contractors
has been substantiallyreduced through the development of detailed procurement regulations.
Beginning with the Armed Services Procurement Regulation of 1949 and continuing through
the updated Federal Acquisition Regulation of 1984,6 these rules stipulate the duties of the
contracting parties and methods of dispute resolution.7 The structure provided by these
general procurement regulations guides the design of permissible contractual agreements
in engine acquisition. The contracting officers in the Engine System Program Office of the
U.S. Air Force have the flexibility to select among alternative contract forms based on
environmental factors and the federal acquisition regulations, subject to approval by the
Acquisition Strategy Panel of the Air Force Systems Command. The set of allowable contractual types, nonetheless, affords the parties substantial freedom in selecting the level of
contractual completeness.
0 Contract types. The degree of completeness is particularly important in selecting the
method for determining contractual compensation. The most restrictive and complete possibility is the "firm-price" contract, in which price is specified to be independent of future
events. Other available types of contingent contracts provide more flexibility, but at the
cost of potentially uncovered possibilities. The most flexible option is the periodic negotiation
of nonbinding target prices. The allowable compensation arrangements, which we now
address in detail, are summarized in Table 1.
The firm-fixed price (FFP)8 contract is the most stringent compensation arrangement.
Price is not subject to any adjustment based on the contractor's cost experience. This approach is most common when production costs or pricinginformation is considered sufficient
TABLE 1
Contract Types
Negotiated Ex Ante
Type
Firm-fixed price (FFP)
Fixed price with economic
price adjustment
(FP/EPA)
Not-to-exceed price
(NTE)
Fixed-price incentive
(firm target) (FPIF)
Fixed-price incentive
(successive targets)
(FPIS)
Negotiated Ex Post
* Price
* No negotiations ex post to change
* Price
* Economic price adjustment formula
price due to contractor's cost
experience
* Only formulaic adjustment to
price as specified ex ante
based on actual or indexed
materials costs
* Ceiling price that may not be
exceeded in payment to the
contractor
* Production point at which a firm
price is to be negotiated
* A firm price
* Target cost, target profit, target price
* Cost sharing formula
* Final cost, final profit, final price
* Initial targets for cost, profit and price
* Cost sharing formula
* Production point at which the firm
* Firm targets for cost, profit and
price
* Final cost, final profit, final price
targets are to be negotiated
6 This is also amended by U.S. Department of Defense (1985).
7 See, for example, the Contract Disputes Act (Public Law 95-563, 92 statute 2383 (1978)), which provides
a system of legal and administrative remedies in resolving government contract claims.
8
Federal Acquisition Regulation ( 1984), part 16.202.
CROCKER AND REYNOLDS
/
131
to permit the negotiation of firm prices ex ante. On the other hand, if parties expect certain
cost components to fluctuate,they may elect to remove from the fixed price major allowances
for such elements. The result is a fixed price with economic price adjustment (FP/EPA)
contract,9 which generally uses specific labor or materials indices to determine prices according to an agreed-uponcompensation formula. In practice,the flexibilityof such a contract
depends upon the number and importance of the indexed categories and is constrained by
the requirement that the contingencies and the compensation formulas must be explicitly
prespecified. Such arrangements are generally restricted to easily foreseen occurrences.
When future contingencies are not quantifiableenough to use a formulaic index, parties
may seek flexibility while constraining seller opportunism by specifying a not-to-exceed
(NTE) ' price initially and leaving to future negotiation the determination of a firm price
at or below the ceiling. This approach entails less prespecification than FP/EPA, as contingencies that may influence the final price are not specifically enumerated, and the final price
is a result of open-ended negotiations. If the parties anticipate that some cost categories
may fluctuate over the life of the agreement, the price ceiling may be loosened by partially
indexing those prices to prespecified cost indices.
When contractual performance involves unforeseen or nonquantifiable contingencies,
parties may adopt a cost-sharing arrangement designed to give the contractor an incentive
to control costs. In a fixed-price incentive (firm target)" (FPIF), parties negotiate ex ante
a target cost, target profit, a profit adjustment formula, and a cost-sharing ratio. If costs are
kept below the target, the contractor receives a share of the savings. Conversely, if costs
exceed the target, the contractor bears a portion of the excess. Consequently, the final price
may be above or below the target price, in contrast with the more stringent NTE, in which
price is constrained to be below the ceiling. The parties may elect to loosen the firm targets
by the prespecification of a target ceiling, leaving the determination of the target price to
future negotiations.
When unforeseen contingencies are expected to be particularlysevere, the parties may
be unable to determine satisfactory targets ex ante. The result is a fixed-price incentive
(successive targets)12(FPIS) contract, in which the targets are successively negotiated as
events unfold and the parties obtain more information. Such negotiations are generally
unstructured, and the determination of final targets is unfettered by any contractual constraints.
o Contractualcompleteness. Historically, a primary concern in procurement contracting
has been that of seller opportunism: the contractor uses a position as the sole provider of
an indispensable product to generate high profit through price increases imposed on the
captive purchaser.13The ability of an agreement to constrain such behavior depends on the
completeness with which the contract determines future prices. The most specific contract
in this regard is clearly the FFP, which permits no adjustments to prices at all. When
9 Federal Acquisition Regulation ( 1984), part 16.203.
10 Title 10 U.S. Code, paragraph2304 (a)( 14).
Federal Acquisition Regulation ( 1984), part 16.403-1.
12 Federal Acquisition Regulation ( 1984), part 16.403-2.
13 Of course, the government, being the sole purchaser, could behave opportunistically as well, demanding
lower prices or requiring(uncompensated) improvements to the product. But the incentives facing the government
and the contractors would seem to be fundamentally different, as the latter is clearly a profit maximizer while the
former, although perhaps facing budgetary constraints, is not. Moreover, the government is constrained from
extreme forms of opportunism by the recognition that such behavior, if affecting the viability of the contractor's
continued operations, could significantly reduce future sources of supply. Contractors, on the other hand, do not
face the prospect of driving the government out of business and, as a consequence, would appear to have the upper
hand in most opportunistic settings.
132
/
TABLE 2
TYPEi, =
=
=
=
=
=
=
=
THE RAND JOURNAL
OF ECONOMICS
Dependent Variable Used in the OLS Estimations
1 if fixed-price incentive (successive targets)
2 if fixed-price incentive (successive targets) with target ceilings
3 if fixed-price incentive (firm target)
4 if not-to-exceed price with economic price adjustment
5 if not-to-exceed price
6 if fixed-price with economic price adjustment
7 if fixed-price with partial economic price adjustment
8 if firm-fixed price
Frequency
Mean
3
6
10
3
1
6
2
13
4.909
escalated by a deterministic economic price adjustment tied to the realized costs of important
inputs, the contract is less complete, yet seller opportunism is constrained by codifying the
pricing mechanism in the agreement. Contracts in which a "not-to-exceed" ceiling price is
specified require future bargaining over price. NTE contracts, therefore, afford substantial
scope for seller opportunism, but do place an upper bound on the most egregious redistributive strategies.In contrast, FPI contractswith firm targetspermit substantialprice increases,
subject primarily to the contractor's ability to document costs. The cost-sharing formula
under which overruns are partially borne by the seller serves as a partial brake on efforts to
inflate price. Finally, an FPI with successive targetsprovides virtually no restriction on seller
opportunism, as the incentive targets are themselves left to future determination through
unconstrained bargaining.
There are also significant differences in the costs incurred by the contracting parties in
the course of negotiating various forms of procurement contracts. These costs include not
only the costs of formalizing the agreement, but also those associated with gathering information about, and crafting optimal responses to, a potentially large set of feasible contingencies. Very unstructured contracts, such as FPIS, permit the parties to negotiate compensation after the relevant contingencies have been revealed, thereby economizing on the
up-front burden of entering the contract. As contracts become more complete, however,
the parties are faced with the prospect of considering increasingly unlikely contingencies ex
ante as the contractor's exposure to the risk of cost escalations intensifies. Moreover, contractors may engage in costly activities designed to shift the increasing risk of cost uncertainty-for example, by using more subcontractors in procurement or stockpiling critical
materials. The number of contingencies requiring attention, in conjunction with efforts by
contractors to insure against cost uncertainty, leads to increasing costs of implementing
more complete contracts.
As a consequence, we may rank the contract types encountered in defense procurement
according to a qualitative index of completeness, as summarized in Table 2, where lower
numerical values correspondto less structuredagreements.Our hypothesis is that the efficient
degree of contractual completeness is reflected in the parties' choice of contract type, which
should therefore be influenced by the environmental factors discussed in Section 2.
4. Air Force engine
contracts:
data
* We have constructed a panel dataset consisting of contracts under which the Air Force
procured jet engines from Pratt and Whitney and General Electric for installation in F- 15
and F- 16 fighters.These aircraftwere designed to counter advances in Soviet weaponry and
required the development of propulsion units with hitherto unattained performance characteristics. The original development contract was implemented in March 1970 with Pratt
and Whitney as the sole contractor, and the firstengines under this agreement entered initial
operation in November 1974. The sole-source regime continued until February 1979, when
CROCKER AND REYNOLDS
/
133
the Air Force began to fund an independent, but functionally equivalent, engine by General
Electric, which was a derivative of the turbine that had been developed for use in the B- I
bomber. This program led to competitive bidding between the contractors in February
1984, resultingin the current scenario of dual sourcing, under which the Air Force purchases
a portion of its fighter engine requirements from both General Electric and Pratt and
Whitney. 114
o Pricing provisions. The pricing provisions adopted by the contracting parties in the
course of this engine procurement have spanned the set of contract forms described in the
previous section. Using the convention for contractual completeness from Table 2, we
present the contractual record in Table 3. The vertical axis identifies the year in which the
contract was negotiated, and the horizontal axis indicates the year in which the engines
under the agreement were actually delivered. Entries correspondto contractual observations,
where contracts with Pratt and Whitney (General Electric) are those without (with) parentheses. For example, the contract for delivery of engines for the calendar year 1973 was
originally negotiated in 1970 as a fixed-price incentive (successive targets) contract. As
indicated by the vertical line, this contract was renegotiated in 1972 to establish firm targets,
resulting in the more complete fixed-price incentive (firm target) contract that governed
the actual price determination. Other contracts, such as the one for delivery year 1983, were
never renegotiated, and in several cases engines were procured for a given delivery year
under multiple contracts, either with the same (1977) or different (1987) contractors.
Several aspects of this contractual record draw immediate attention. The first is the
extensive use of contract renegotiation, particularly when the period between contract negotiation and delivery is substantial. These mutually agreed-upon modifications to the original contractare referredto as "supplementalagreements,"and they "createnew and different
legal relations between the parties and are, in effect, new contracts." 15Altogether, there are
44 differentoriginaland renegotiatedcontractsbetween the Air Force and the engine suppliers
governing engine procurement. Contracts with remote performance horizons tend to be
less structured initially, anticipating renegotiation to a more complete form at some future
date, while those with more proximate performance deadlines are initially more complete.
A second important characteristic of the data is that contracts governing engine procurement have become substantially more complete over time. In the earlier stages of procurement, the less structuredFPIS contracts were used. More recently, the highly structured
FFP contract, in some cases escalated by a deterministic EPA clause, appears to be the rule.
A final point worth noting is the apparentasymmetry in the procurementcontractsnegotiated
contemporaneously with the two contractors. With the exception of the 1986 delivery year,
the General Electric contracts are systematically less complete than Pratt and Whitney's.
Clearly, in the course of this procurement there is substantial variation in pricing processes,
both across contractors and over time.
o Explanatoryvariables. The discussion in Section 2 suggeststhat the degree of contractual
incompleteness chosen by the parties should reflect the tradeoff between the costs of implementing more complete agreements and the benefits arising from a reduction in opportunistic efforts to redistributethe contractual surplus. Environmental characteristicsleading
to an increased likelihood of contractor opportunism should make contracts more complete,
14 An entertaining and descriptive account of these relationships is contained in Drewes ( 1987), in which the
decision by the Air Force to engage in dual sourcing appears to be driven by dissatisfaction with the performance
of the F100/200 engine and the apparent unresponsiveness of Pratt and Whitney to Air Force concerns in this
regard.
15 Air Force Institute of Technology ( 1986), Vol. II, p. 50. See also Federal Acquisition Regulation, parts
43.101, 43.102, and 43.103.
134 /
THE RAND JOURNAL OF ECONOMICS
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CROCKER AND REYNOLDS
/
135
while characteristics that increase the costs of crafting precise agreements should result in
less structure. First we shall consider variables that shift the marginal benefits of contractual
completeness, then turn to those affecting the marginal costs.
Although a contractor's likelihood of engaging in future opportunistic behavior (L)
cannot be observed directly, past experience may serve as a useful guide. Agents having a
historical propensity to cooperate in resolving contractual disputes are more likely to take
the longer view in an exchange relationship, whereas those who have been opportunistic
and litigious in the past would be likely to be so in the future. Several Air Force contracting
officers with whom we spoke perceived the behavior of a defense contractor to depend on
companywide policies set by the parent for all its subsidiaries.Their experience has indicated
that the approachof the parent company and the other subsidiariestoward dispute resolution,
as representedby past litigation strategies, provides guidance on a contractor's likely future
behavior. Indeed, the contracting officers in the Engine System Program Office are required
to read the Federal Contracts Report, a weekly summary of cases involving defense contractors, their parents, and subsidiaries, as well as similar publications, in order to remain
current on developments in litigation.
To capture this reputational effect, we include as an explanatory variable DISPUTES,
defined as the number of cases argued and determined involving the contractor, the parent
company, or other subsidiaries for the five years preceding the date of a contractual observation.16 The time trend of this variablefor both of the contractorsin our sample is displayed
in Figure 2, where differences in corporate behavior are immediately apparent. While the
record in the case of General Electric appears to be relatively stable over time, that of Pratt
and Whitney exhibits a substantial increase in litigation. To the extent that past willingness
to engage in adversarial proceedings increases the likelihood of future opportunism, we
expect DISPUTES to increase the marginal benefits of more complete agreements.
The likelihood of future opportunism depends not only on a contractor's inherent
proclivity to opportunism, but also on the potential success of opportunism in effecting a
favorable redistribution. One obvious impediment to contractor opportunism is the availability of alternative suppliers. Our sample of contracts includes data from periods in which
there was a single provider of engines, as well as a period in which dual sourcing was
practiced.Accordingly, we use the dichotomous variableDUALDUM as an additional proxy
for L; the hypothesis is that the availability of alternative suppliers reduces the potential
success, and hence the likelihood, of contractor opportunism, leading to the adoption of
less complete agreements.
One of the primary sources of environmental uncertainty (W) facing parties during
contractual negotiations over a deferred exchange is the difficulty of predicting future economic conditions with any confidence. We capture the increasing uncertainty associated
with long time horizons in the variable TIMEPERF, defined as the number of calendar
quarters between the completion of contractual negotiations and the beginning of engine
delivery.17The hypothesis is that more distant dates of contract performance increase environmental uncertainty and the costs of implementing more complete contracts, leading
to more incomplete exchange agreements.
16 The five-year lag was selected because Air Force contracting officers are generally reassigned within five
years. The DISPUTES variable included appeals filed by the contractors of Air Force contracting officer decisions,
as well as appeals filed by the military departments in the Armed Services Board of Contract Appeals. Also included
are suits filed by private citizens or firms against the defense contractor, its parent, or other subsidiaries, and vice
versa, in the U.S. district court system, the United States Claims Court, with the Comptroller General (in the case
of bid protests), and the federal appellate court system.
17 In some cases, TIMEPERF was negative. In these cases, the variable was truncated to zero, since there is
no intertemporaluncertainty associated with a past event.
136 / THE RAND JOURNALOF ECONOMICS
FIGURE2
Disputes
40
-General
Electric
-Pratt
and Whitney
30
20
10
0651 661671681691 70171172173174175176177178179180181 182183184185186187188
Calendaryear
Another important source of environmental uncertainty stems from the use of innovative and largely untested technologies in the design and development of engines. In the
initial phases of engine production, the high degree of technological uncertainty results in
FIGURE3
UIERs
25
_________________
-General
-Pratt
20
-Pratt
ElectricF110
and WhitneyF100/200
and WhitneyF220
15j
*
I.
,
5
10
175176 177 178 179 180 181182
183 184 185 186 187 188 189 190
Calendaryear
CROCKER AND REYNOLDS
/
137
substantial cost uncertainty that gradually, but irregularly,diminishes as problems are identified and corrected.While the technological uncertaintyfacing the partiescannot be observed
directly, its result is shown by the reliability of the engines actually produced. We have
obtained data from the Air Force Logistics Command on engine reliability, identifying
instances of engine failure severe enough to require removal of the propulsion unit from
the airframeprior to regularlyscheduled maintenance. Figure 3 shows the time series record
for the unscheduled engine removals (UERs) per thousand hours of flying time, and it
indicates how the technological uncertainty facing the contracting parties changed over the
sample period. In particular, note that the introduction of the Pratt and Whitney F 100 /
200 and the General Electric Fl 10 engine systems was accompanied by significant reliability
problems, which can be attributed, at least in part, to the fact that these were entirely new
engine designs. On the other hand, the Pratt and Whitney F220 has enjoyed a superior
reliability record, perhaps because it was a higher-powered derivative of the earlier Pratt
and Whitney engine and therefore benefited from that experience. A second point is that
TABLE 4
Explanatory Variables
Variable
Definition
Mean
TIMEPERFit =
Number of calendar quarters from the
contract signed with contractor i at
date t to the year of engine delivery
The number of litigated outcomes
involving contractor i, the parent
company, or the parent company's
subsidiaries in the 21 calendar
quarters prior to the signing of the
contract at date t
The number of calendar quarters
between the signing of the contract
i at date t and the first quarter of
1970
1 if contracting occurred in a dualsourcing environment
0 if contracting occurred in a solesource environment
1 if the contracting party is Pratt and
Whitney
0 if the contracting party is General
Electric
The average unscheduled engine
removal rate (per thousand hours
of flying time) for the two years
following the delivery year of the
contract
1 if the contract is a supplemental
agreement
0 otherwise
The number of calendar quarters
between the signing of the
supplemental agreement and the
original contract governing the lot
purchase if SA = 1
0 if otherwise
The number of calendar quarters
elapsed since the first contract was
signed for the engine type governed
by the contract
9.8182
0
28
6.4091
1
15
37.955
0
66
.409
0
1
.795
0
1
5.905
.59
11.73
.295
0
1
3.591
0
25
19.545
0
62
DISPUTESi, =
QTRSi,
=
DUALDUMit =
=
PWDUM1t
=
UER2it
=
SAit
=
LOTQTRSit =
RSINVST1, =
Minimum
Maximum
138
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THE RAND JOURNAL
OF ECONOMICS
after the initial reliability problems, the performance record for the new designs improved
steadily, indicating learning and a reduction in technological uncertainty over time.
When negotiating a contract, the parties have expectations about the degree of technological uncertainty likely to be experienced in the course of contractual performance.
The particular sources of this information, such as test results on the durability of turbine
blades in an engine or in related applications, are not observable to the econometrician.
We assume that agents have accurateinformation on the incidence of technological problems
at the time contracts are negotiated, and that their expectations are rational. The actual
reliability of the engines produced should accurately reflect the agents' ex ante beliefs about
the degree of technological uncertainty.18To capture this effect, we include as an explanatory
variable UER2, which is the average UER rate for the engines in the two calendar years
following delivery. The hypothesis is that increasing technological uncertainty, as reflected
by a reduction in the reliability of engines after delivery, should increase the cost of crafting
more complete contractual agreements.
As an alternative to engine reliability as a measure of uncertainty, we also include
results using the variable QTRS, which is defined to be the number of calendar quarters
between contract signing and the date of the original procurement contract in 1970. This
alternative measure should capture any macroeconomic trends or cumulative learning curve
effects, and it should serve to provide evidence on the robustness of the other coefficient
estimates. To the extent that technological uncertainty diminishes over time, we would
expect the estimated coefficient on QTRS to be positive, reflectingthe use of more complete
agreements as contractor experience with the technology matures. The explanatory variables
used in the estimations that follow are summarized in Table 4.
5. Empirical results
* The empirical relationshipdescribingthe choice of contractualcompleteness as a function
of the variables that shift the benefit and cost schedules may be written as
Yit = ai + fcoit +
yLit +
Eit,
(2)
where Y11is the degree of contractual completeness specified in the contract signed with
are variablesaffecting the marginal
contractor i in date t, oi is a contractor-specificeffect, coiw
cost of contractualcompleteness when contractingwith i at time t, and Li, representsvariables
that increase the likelihood, as seen from the time of contractual signing t, that contractor
i would engage in future redistributive activities. We require that the sEibe independent
and identically distributed error terms with zero mean and constant variance a 2, and that
COV (yEj, Eki') = 0 for every t # t', j * k. Below we will discuss potential problems with the
assumptions regardingthe error structure of the model.
Straightforwardestimates of the empirical relationship (2) using ordinary least squares
(OLS) are presented in Table 5. The first column omits both firm and dual-sourcing effects,
and it has fewer observations (38) because the UER data are available only through calendar
year 1990, so UER2 cannot be computed for the last six contract observations in the data.
Nonetheless, the estimated coefficients are highly significant and of the hypothesized sign,
so that a history of litigiousness (DISPUTES) generatesmore complete agreements,whereas
an increase in intertemporal or technological uncertainty, as represented by TIMEPERF
or UER2, results in the adoption of more complete contracts. The second column contains
18 An interesting parallel is provided by the approach adopted in Hansen and Singleton ( 1983 ), who assume
that agents, when making their monthly consumption plans, know the actual market return on assets that will
prevail during the month the plan is in effect. In a related vein, Ahmed (1987) examines a model of government
spending in which agents perfectly forecast the actual length of wars, and hence the magnitude of war-related
expenditures, at the outset of the conflict.
CROCKER AND REYNOLDS
TABLE 5
Variable
CONSTANT
DISPUTES
TIMEPERF
UER2
(1)
(2)
(3)
(4)
(5)
(6)
5.328
(5.168)a
.3397
(6.449)a
-.1181
(-4.024)a
2.069
(5.693)a
.2865
(6.534)a
-.0897
(-5.060)a
7.029
(6.549)a
.4211
(7.588)a
-.1216
(-4.651)a
-.2139
( -2.040)b
3.537
(3.663)a
.3916
(6.266)a
-.0911
(-3.989)a
5.268
(5.897)a
.4079
(8.087)a
-.1172
(-4.820)a
-.2982
(-2.986)a
1.595
(3.069)a
.3662
(6.104)a
-.0654
(-2.751)a
-.2665
QTRS
.0496
-
(4.272)a
DUALDUM
R2
Log-likelihood
Observations
139
OLS Estimation Results (t-ratios in parentheses)
( - 2.463)b
PWDUM
/
-
-
.84
-56.158
38
.86
-58.999
44
.0359
-
-1.256
(- 1.77 1)C
-2.385
(1.840)
-1.125
-1.505
(- 1.662)`
-1.440
(-2.328)b
-
(-3.605)a
(-2.162)b
.89
-49.54
38
.88
-55.99
44
.91
-39.69
33
-
.0525
(2.705
-1.496
(-2.304)b
-
.91
-42.14
35
aSignificant beyond the 1%level.
b
Significant beyond the 5%level.
c Significant beyond the 10%level.
a parallel set of estimates, with UER2 replaced by QTRS. Once again, the estimated coefficients are significant at conventional levels and consistent with the hypotheses on the
choice of contract type.
o Additional explanatory variables. If the model were misspecified by the omission of
explanatory variables from the regression, and if the omitted variables were correlated with
those included in the estimation, then the error term would no longer be uncorrelated with
the (included) explanatory variables. The result would be biased and inconsistent estimates
of the true parameter values. The first, and most obvious, source of omitted-variables bias
would be the potential for firm-specific effects. Were the choice of contract type driven by
unobserved attributes particular to each contractor, observable variables correlated with
firm identity that were included in the regression would (mistakenly) appear to have explanatory power. Our panel data permit the inclusion of firm-specific dummy variables to
correct for this possibility.
A second potential source of bias would arise from ignoring a regime change, such as
the movement from single to dual sourcing of engine procurement, in the time series.
Considera scenario in which an institutional change in the government procurement process
led to an emphasis on tighter contracts and the use of dual sourcing in procurement. Such
a hard-nosed attitude from the government might also be expected to increase contractual
disputes, so that inclusion of DISPUTES in a regressionwithout consideration of the regime
change could lead to erroneous conclusions about the causal effect of contractor reputation
on the choice of contract type.
To account for the possibility of firm- or regime-specific effects, we include in the
regressionsthe dichotomous variables PWDUM and DUALDUM, the results of which are
reported in columns 3 and 4 of Table 5. The hypothesized relationships continue to be
supported in these estimations, and both of the included dummy variables are negative and
significant at conventional levels. That the parties adopt looser contracts in a dual-source
regime accords with the predictions of the model, since the existence of alternative suppliers
is likely to reduce the potential for contractor opportunism. Perhaps more surprising are
the results indicating that contracts with Pratt and Whitney are less complete than those
140
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THE RAND JOURNAL OF ECONOMICS
with General Electric, particularlygiven the rather stormy relationship between the former
and the Air Force during the 1970s. One might have expected that as a consequence of the
substantial disagreements and allegations of opportunism, a bias against Pratt and Whitney
might have developed, resulting in significantly tighter agreements. These results indicate
the existence of no such firm-specificbias against Pratt and Whitney favoring more complete
contracts independent of the effects captured by the other explanatory variables.
There is, of course, the possibility that the dummy variable specification does not fully
capture the firm-specificeffects, so for comparison we have also included estimations using
a subset of contract data consisting only of contractswith Prattand Whitney. These coefficient
estimates, which are presented in columns 5 and 6 of Table 5, indicate that the results
supporting the hypothesized relationships are not driven by firm effects and are, instead, a
consequence of the time-varying explanatory variables.
A final source of potential omitted-variables bias arises from the fact that some of the
contractual observations in the dataset are contract renegotiations, actions that were anticipated in the initial agreements. For example, FPI contracts with successive targetsanticipate
a renegotiation in the future to set firm targets, and NTE contracts require the negotiation
of firm prices at some date. The question, then, is whether there is something special about
a contract's being a supplemental agreement that could affect the estimates of the other
coefficients. To account for this possibility, we include in the regressions two alternative
variables, SA and LOTQTRS. SA is a dummy variable showing the observation to be a
supplemental agreement, and LOTQTRS is defined as the number of calendar quarters
between the original contract pertaining to a particulardelivery year ("lot") and the relevant
supplemental agreement. The former is included to capture any effects specific to all supplemental agreements,while the latteraddressesthe possibility that supplemental agreements
may have differing effects on the choice of contract type, depending on the time elapsed
since the original agreement was signed. The estimations including these variables are presented in Table 6. The results continue to support the hypothesized relationships, and the
TABLE 6
Variable
CONSTANT
DISPUTES
TIMEPERF
OLS Estimation Results (t-ratios in parentheses)
(1)
(2)
(3)
(4)
(5)
-.6186
(-.922)
-2.179
(-3.872)'
-.3223
(-.812)
-1.147
(-1.625)
-2.364
(-3.617)'
-.6285
(-1.336)
(2.285)
(2.216)b
SA
LOTQTRS
R2
Log-likelihood
Observations
.87
-57.50
44
.89
-48.48
38
aSignificant beyond the 1%level.
b Significant
(8)
7.751
3.673
5.369
7.434
3.673
8.547
3.123
(6.513)a
(3.842)a
(8.813)a
(6.726)a
(3.903)a
(5.776)a
(2.561)b
.3799
.3441
.4368
.3808
.3296
.3519
.2739
(6.042)a
(4.947)'
(8.048)a
(6.053)a
(4.731)a
(4.392)a
(2.890)a
-.1475
-.1024
-.1267
-.1454
-.1062
-.1530
-.1009
(-4.568)a (-4.305)a (-5.483)'
(-4.605)a (-4.483)'
(-4.009)a (-3.463)a
-.2383
--.2104
-.3152
(- 2.265)b
(-2.028)c
(-2.269)b
.0445
.0447
.0618
QTRS
PWDUM
(7)
5.300
(8.245)a
.4505
(8.520)a
-.1219
(-5.245)a
UER2
DUALDUM
(6)
beyond the 5% level.
cSignificantbeyond the 10%level.
-1.055
-.4857
(-1.578)
(-.715)
-1.321
-2.130
(- 1.998)c (-3.832)'
-.5799
(-1.466)
-.0339
(-1.224)
.89
.88
-54.75
-57.02
44
44
-.9873
(-1.350)
-2.311
(-3.520)'
(2.27I)b
-.8957
(-1.339)
-1.238
(- 1.886),
-1.163
(-1.311)
-2.499
(-3.085)'
-.0494
(1.815)c
.89
-54.12
44
-
-.8935
(-1.087)
-.9201
(-1.066)
--
-.0419
(-1.312)
.89
-48.56
38
.89
-37.20
27
.88
-42.05
31
CROCKER AND REYNOLDS
/
141
only change is that support for the effect of dual sourcing on the choice of contract type is
reduced considerably. The dummy variable SA is never significant, and LOTQTRS exhibits
significance only in the results reported in column 6. Moreover, for purposes of comparison
we provide results from estimations restrictedto the subsample of contracts consisting only
of original agreements, reported in columns 7 and 8. The coefficient estimates are largely
unchanged, which further reinforces the conclusion of the absence of effects specific to
supplemental agreements in the selection of contract type.
Ol Ordinal dependent variables. An additional concern is that the OLS regression results
reported above treat contract type as a continuous variable. Although the selection of contractual completeness is by nature continuous, the observed choices are discrete types, and
the use of OLS may result in inconsistent estimates.'9 An appropriateestimation technique
when the observed categories are ordered with respect to an underlying latent variable (in
this case, contractual completeness) is ordered probit. To make the estimations tractable,
we have consolidated the contract types to reduce the number of cells from nine to six,
using the variable TYPEP, which is formally defined in Table 7.
The results from the ordered probit estimations are contained in Table 8, and are
largely consistent with those encountered in the OLS analyses. Columns 1 and 2 present
the basic results without any omitted-variables corrections. The estimations correcting for
potential firm- or regime-specific effects are those in columns 3 and 4, where neither of the
dummy variables is significant. There is, however, a reduction in the significance of the
reputational variable DISPUTES, although the estimated coefficient remains of the hypothesized sign. The final four columns contain estimations with the corrections for effects
specific to supplemental agreements, neither of which is significant at conventional levels.
0
Endogeneity. A potential problem with the estimation procedures used above is the
possibility for simultaneity, leading to inconsistent parameter estimates and incorrect standard errors. One candidate for endogeneity would appear to be DUALDUM, since the
funding of alternative sources of supply is a choice variable under the control of the Air
Force. The decision to dual source, however, is made well in advance of the contract negotiations that determine contract type. Although the existence of an alternative engine
supplierwas a consequence of an Air Force funding decision made in 1979, the firstcontracts
negotiated under the competitive procurement regime were in 1984. Whether a contractor
TABLE 7
Dependent Variable Used in the Ordered
Probit Estimations
TYPEPi, = 0 if TYPEj, = 1
= 1 if TYPEj, = 2
Frequency
Mean
3
3.068
=2ifTYPEj,=3
= 3 if TYPEj, = 4 or 5
= 4 if TYPEj, = 6 or 7
6
10
4
7
=5ifTYPEj,=8
13
'9 The problem arises as a result of the cardinality imposed on the ordinal variable TYPE when applying
OLS. This can be seen with reference to an ordered probit model (see Maddala ( 1983)). Consider the underlying
relationship Y, = OX, + ej (i = 1, 2, . . . n), where Y is an unobserved latent variable, X is a set of explanatory
variables, and e is a random disturbance. We cannot observe Y directly, but we can observe a category in which
the latent variable is contained. That is, we know Y is contained in categoryj if gjfI < Y < gj. The use of ordered
probit results in estimates of the thresholds A as well as (implicitly) the distance between them. The use of OLS
exogenously assigns both.
142
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THE RAND JOURNAL
TABLE 8
Variable
CONSTANT
DISPUTES
TIMEPERF
UER2
OF ECONOMICS
Ordered Probit Estimation Results (t-ratios in parentheses)
(1)
(2)
6.949
(2.376)b
.3849
(2.743)a
-.2244
(-2.108)b
1.510
(1.574)
.3759
(3.250)a
-.1591
(-2.757)a
-.4543
(-1 .956)C
QTRS
(3)
(4)
8.666
2.454
(1.042)
.5264
(1.564)
-.1405
(2.281)b
.4688
(1.206)
-.2463
(-2.074)b
-.4005
(-1 .682)C
(-1.915)c
(5)
(6)
7.332
1.905
(1.719)r
.3616
(3.119)
-.1870
(2.267)b
.3791
(2.602)
-.2409
(-2.014)b
-.4678
(-1 .869)C
(2.542)
-.2348
(-1.987)b
1.949
(1.747)c
.3561
(2.895)
-.1904
(-2.633)a
-.4498
(-1 .870)C
.0949
.1056
.1087
(3.472)a
(1.758)C
(3.097)a
(2.796)a
-.7832
PWDUM
-2.307
(-.148)
(-.555)
-1.958
-1.515
(-.509)
(-.506)
-
-.3780
SA
(-.399)
-27.68
44
-22.60
38
-26.81
44
-24.62
38
-
-.8114
(-1.065)
-
LOTQTRS
-24.79
38
7.084
(2.302)b
.3846
(8)
.0928
DUALDUM
Log-likelihood
Observations
(-2.610)
(7)
0191
-26.67
44
(-.304)
-24.69
38
-.0692
(-.996)
-26.18
44
a Significant beyond the 1%level.
b Significant beyond the 5% level.
c Significant beyond the 10%level.
will face a potential competitor is effectively already determined by the time the parties
meet to negotiate, and therefore it is an exogenous variable in the choice of contract type.
A potentially more serious endogeneity problem is associated with the variable
TIMEPERF, and is a consequence of the determination of both contract duration and type
during negotiations. While in principle the system could be recursive, where duration affects
the choice of contract type but not vice versa, we have no model at hand that indicates
such a relationship.20To investigate endogeneity, we use a specification test suggested by
Hausman (1978). This test involves comparing the OLS or ordered probit coefficient estimates with those of an alternativeestimator that is consistent even though some explanatory
variables may be endogenous. In our case, the alternative estimator entails the use of instrumentalvariables.To apply the specificationtest, we ( 1 ) regressthe potentially endogenous
variable on the set of exogenous instrumental variables, (2) include the fitted value from
this regressionas an additional explanatoryvariablein the original models, and (3) determine
whether the fitted value provides statistically significant explanatory power. A significant
fitted value permits a rejection of the null hypothesis that the variable in question is
exogenous.
Accordingly, we generate predicted values for the variable TIMEPERF using the instrumental variables described below. Table 9 reports goodness-of-fit (R2) as well as the
significance of the identifying variables. Previous work on long-term contracts has indicated
a primary determinant of contract length to be the magnitude of the relationship-specific
investment required to effect exchange.21 Although we have no direct measure of this investment, we can use as a proxy the variable RSINVST, defined as the number of calendar
quarters that have elapsed between the contract at hand and the initial contract governing
20 This is the case in Crockerand Masten ( 1988) and Masten and Crocker( 1985), where take-or-payobligations
are determined first, and then contract length adjusts to the size of the take percentage.
21 For example, Joskow ( 1987) or Crocker and Masten ( 1988).
/
CROCKER AND REYNOLDS
TABLE 9
143
Hausman Test Statistics (Significance levels in brackets)
OLS
(1)
(2)
(3)
(4)
(5)
(6)
1.087
[.28]
.044
[.96]
2.381
[.02]
.882
[.38]
.097
[.92]
2.224
[.03]
Ordered Probit
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
.361
[.72]
.044
[.96]
.732
[.46]
-.553
[.59]
-.128
[.89]
-.375
[.71]
-.176
[.86]
-.265
[.79]
Instrumental Variables Estimation (Dependent variable: TIMEPERF)
Observations
R2
Instruments
38
.79
44
.71
DISPUTES, PWDUM, QTRS*,
DUALDUM, UER2, SA, LOTQTRS,
RSINVST*
DISPUTES, PWDUM, QTRS, DUALDUM,
SA, LOTQTRS, RSINVST*
Significance Level of
Identifying Variables
[.00000]
[.00003]
* Denotes identifying variables.
the production of the associated engine type. The intuition is that the introduction of a new
engine, such as the Pratt and Whitney F 100 / 200 and F220 or the General Electric FI I0,
requiressubstantial relationship-specific investment in research, development, and production facilities, the costs of which are slowly amortized as engines are produced in follow-on
contracts. As the contractor recovers the capital investment, the size of the relationshipspecific investment remaining declines, leading to a reduction in the duration of future
agreements. Indeed, the negative coefficient on RSINVST in the instrumental-variables
regressionsof TIMEPERF is strongly supportive of this interpretation.
The Hausman test, in the case of a single potentially endogenous variable, turns on
the significance of the fitted value when included in the full regressions. Table 9 reports the
t-ratios and significance levels for the predicted values of TIMEPERF when included as an
additional explanatory variable in the regressions of the first six columns of Table 6 and
those of Table 8, with the result that the null hypothesis of exogeneity can be rejected in
only two cases, both of which use the variable QTRS instead of UER2 to capture the effect
of technological uncertainty.22In all of the specifications using UER2 and all of the ordered
probit estimations, the null hypothesis of TIMEPERF exogeneity cannot be rejected, so
endogeneity does not appear to be a serious consideration in the interpretation of the coefficient estimates.
ol Discussion. These empirical results provide substantial insights into the interpretation
of the contractualrecordpresentedin Table 3. The significantand negative effect of RSINVST
on TIMEPERF suggests that the long-term contracts encountered in 1970 and 1984 were,
at least in part, adopted to guarantee the contractor's recovery of expenditures for devel22
In addition, we have run the two-stage least squares regressions for the two specifications contained in
Table 7 where exogeneity is rejected, with the result that all coefficients maintain the hypothesized sign and are,
with the exception of TIMEPERF, significant at conventional levels.
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THE RAND JOURNAL
OF ECONOMICS
opment and investment in relationship-specific capital for the production of new engine
varieties. The distant performance horizons increased the cost of crafting more complete
contracts, leading to the implementation of less structuredbargains. This effect can be seen
most clearly in the exchange agreements negotiated in 1984, which are increasingly incomplete as performance becomes more remote.
This incentive to adopt initially incomplete contracts is reinforced by the extensive
technological uncertainty encountered by Pratt and Whitney in the beginning stages of its
F 100/200 production schedule, as shown by the reliabilityrecord summarized in the variable
UER2. The potential for engine deficiencies uncovered in early tests generated substantial
uncertainty about the cost of producing an acceptable engine. This uncertainty, in conjunction with the distant date of engine delivery, led in the early stages of engine procurement
to the adoption of the very incomplete FPIS contractual arrangement. As the technological
problems with the engine were ironed out, however, the cost of implementing more complete
contracts declined, leading to the adoption of the stringent FFP contract in later years.
Also apparent in the contractual record of Table 3 is a substantial difference in the
nature of the contracts negotiated contemporaneously with Pratt and Whitney and General
Electric in the dual-source regime. While this might appear to be a firm-specific effect, the
empirical results of this article indicate the differential to be a consequence of other explanatory variables. The historical record of Pratt and Whitney with regardto litigation, as
summarized by the variable DISPUTES, is indicative of an opportunistic philosophy that
stands in sharp contrast to that exhibited by General Electric. Moreover, the reliability of
General Electric's initial F110 engine was substantially inferior to that of its competitor,
the Pratt and Whitney F220. Both of these effects would be predicted to cause contracts
with General Electric to be less complete than those negotiated with Pratt and Whitney.
A final characteristicof the contractual record is that agreements tend to become more
complete over time. This monotonic relationship is a consequence of the natural resolution
of technological and intertemporal uncertainties as events unfold, which appears to be the
driving force behind the design of the engine procurement contracts. This one-way ratchet
reflects participants' realistic expectations about technological progress and, in particular,
the lack of mistakes serious enough to warrant renegotiation toward less, as opposed to
more, complete agreements. The monotonic nature of the pricing provisions in our data,
and the inviolability of firm-fixed prices once adopted, indicate an environment in which
the contracting parties possessed accurate expectations at the time of contract negotiation.23
Our results also have several implications for procurement policy more generally. The
first concerns the emphasis by policymakers in the mid-1980s on firm-fixed pricing in development contracts to constrain seller opportunism and to contain cost overruns.24While
23
This experience, however, has not been universal, as unanticipated problems with product development
in other procurement environments have resulted in a backtracking of sorts, where initially firm prices were renegotiated to a more flexible, and less complete, pricing process. Probably the best example of this experience was
suggestedto us by a refereeand involves the relationshipbetween the Navy and General Dynamics in the construction
of the SSN-688 (Los Angeles class) and Trident (ballistic missile) submarines. The initial contracts were firm-price
agreements, which led to extensive cost overruns and mutual recriminations over fixing blame. The result was a
congressionally approved restructuringof the contracts, permitting partial reimbursement of the cost overruns (see
McNaugher ( 1989) and, for a more detailed account, Tyler ( 1986)). In light of the more than 5,000 documented
design changes incurred in the course of SSN-688 production, it would seem that the parties faced a high degree
of technological and design uncertainty ex ante, making contracts with tight price ceilings inappropriate in this
context. Of course, an alternative argument could be that the initial contract was strategically lowballed by the
contractor to gain a sole-source position from which to renegotiate a more lucrative compensation arrangement.
While this hypothesiscannot be definitivelyrejected,it would seem that contractorsanticipatingstrategicrenegotiation
would prefer looser contracts where such negotiations are permitted as a matter of course, as opposed to a stringent
firm-fixedprice contract where strategic behavior required a high-profile repudiation of the initial agreement.
24 See "Pentagon Backs off from Two Cost Policies, Saying Suppliers Deserve Fairer Shake," Wall Street
Journal, April 14, 1988, and other sources in Burnett and Kovacic (1989).
CROCKER AND REYNOLDS
/
145
more complete contracts certainly suffice to mitigate ex post redistributive efforts by contractors, our analysis indicates that such benefits may be dwarfed by the costs of drafting
truly complete agreements, particularlyin complex exchange environments. A second, and
related, point is that procurement officers should be granted the latitude to craft agreements
on a case-by-case basis, where the design of a particular contract would depend on the
specifics of both the product and the contractors. Any policy attempting to impose homogeneity in contract design either across contractors or over time would be misguided, and
likely to significantly raise the costs of effecting contractual exchange. A final implication
concerns the potential benefits accruing from the use of dual sourcing. While other authors
have been concerned with the cost and pricing effects of split awards,25 dual sourcing may
also generate resource savings in the drafting of contracts by permitting the implementation
of less complete agreements. The discipline provided by the existence of an alternative
suppliermitigatesthe necessity for a complete, and costly, contractualdocument to constrain
future contractor behavior. This suggests that split awards may provide substantial administrative as well as pricing benefits in weapons procurement.
6. Conclusions
* Many authors have examined the incentives created by incomplete agreements and
concluded that investment distortions and the use of resource-consuming tactics in redistribution diminish the contractual surplus. The standard assumption in these studies is one
of exogenously, and immutably, imposed contractual incompleteness. In contrast, our concern has been with the endogenous choice of the degree of contractual completeness and
the incentives facing agents to enter agreements that are left intentionally incomplete. Contracting parties face a tradeoff between the costs of drafting a more complete document and
the losses associated with incomplete agreements.
The results of our empirical work provide strong support for the proposition that the
degree of contractual incompleteness chosen in practice reflects the relative magnitudes of
these economic costs. Variables associated with higher levels of environmental complexity,
such as technological uncertainty or remote dates for contract performance, increase the
costs of drafting complete contracts and result in the adoption of less exhaustive arrangements. A record of past opportunistic behavior or the potential for hold-up in a sole-source
environment, on the other hand, increases the likelihood of ex post redistributive efforts
with the attendant bargaining costs, and results in the use of more complete contracts. We
conclude that the degree of incompleteness is an important choice in contract design, and
that it reflects the parties' desire to minimize the economic costs of a contractual exchange.
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