Are relative completeness of contracts and of contract governance arrangements necessary conditions for successful procurement?

Contracts can be, and are often deliberately designed to be incomplete. This is because there is a trade-off between the present costs of drafting a more complete agreement and the later inefficiencies stemming from the absence of exhaustive arrangements. Hence, environmental complexities that increase the costs of contract drafting can be expected to lead to lower completeness of the most efficient contracts, while more exhaustive contracts can be expected to be drafted only under conditions of increased potential for later inefficiencies. Consequently, the degree of contractual completeness is a product of an attempt by the parties involved to minimize the net economic costs of contractual exchange (Crocker & Reynolds, 1993).

Defense procurement normally involves high, reoccurring investments into relationship-specific assets provided by a relatively small group of highly specialized contractors. Moreover, due to extensive lead times and costs of development and production of major weapons systems, the government ends up being tied to particular contractors once the contract is signed and the work begins (Crocker & Reynolds, 1993). Consequently, there is a high administrative burden on the government, which involves the selection, governance and compensation of multiple private contractors. As a result, detailed procurement regulations have been developed to substantially reduce this burden. These regulations list the duties of the contracting parties, as well as the methods of conflict resolution between them; and provide the structure for the design of permissible contractual agreements (Crocker & Reynolds, 1993). Consequently, the governmental contractual officers are expected to take environmental factors into account and following the relevant regulations select the most appropriate contract from among the alternative forms open to them, subject to more senior approval. In spite of this considerable amount of regulations, the various forms of contract which can be chosen by the contractual officers from among the alternatives, allow them to choose contracts with various levels of completeness (Crocker & Reynolds, 1993).

Contractual compensation is particularly sensitive to the degree of completeness inherent in the contract which outlines it. The most restrictive and complete contract in this respect, is the “firm-price” contract, which sets a fixed price and declares that this fixed price will remain unchanged irrespective of future events (Crocker & Reynolds, 1993). Other types of contracts allow the price to fluctuate to various degrees due to possible future events, and thus carry various degrees of risk of future difficulties, if the future event does not fall neatly into any of the categories outlined in the contract. The most flexible and the least complete contract of this type is the one which allows for the periodic negotiation of nonbinding target prices (Crocker & Reynolds, 1993).

References

Crocker, K. J. and Reynolds, K. J. (1993). The efficiency of incomplete contracts: An empirical analysis of air force engine procurement. The RAND Journal of Economics, 24(1), 126-146.