Optimal Incentive Contract with Asymmetric Cost Information

Abstract

As a prevalent problem for construction projects, contractor cost details are unobserved or unknown to the owner. This paper considers a risk-averse owner (he) who engages a risk-neutral contractor (she) to complete a project when the contractor’s overtime cost information is unknown to the owner. The owner designs a menu of incentive contracts for the contractor to choose/to negotiate with the contractor to maximize his profit. The incentive payment is determined by the saved time relative to the predetermined deadline. We provide optimal incentive contract menus under symmetric and asymmetric information settings, respectively. Moreover, by comparing the terms of optimal incentive contracts under both information settings, we find that even though the duration of a low-cost contractor will not change with the information setting. However, the owner has to pay more to induce the low-cost contractor to choose the appropriate contract under the asymmetric information setting. Meanwhile, the high-cost contractor receives less payment and completes the project later under the asymmetric information setting. In addition, we find the value of information increases with the level of risk aversion and the gap of costs, and is concave with respect to the probability of high-cost type or that of low-cost type. Finally, we use real data to verify our theoretical findings.