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Finally, DoD contracting practice would be greatly enriched by viewing defense
transactions through the lens of TCE. An important insight is the opportunity to craft
contracts based on the potential for opportunistic behavior, in addition to varying incentives
based on shifting risk. Where there is significant scope for opportunistic behavior, contracts
should pay special attention to the use of additional mechanisms to govern the outsourcing
relationship. This suggests that existing guidance on contract types should be extensively
revisited—an important first step in translating the theoretical insights of TCE into DoD
practice.
APPENDIX A. A TCE BARGAINING GAME MODEL
A game is developed between two parties in a transaction (i=1,2) whose combined
productive efforts endogenously generate the surplus:
(1)
S = Ae
α α
e
1 2
1 2
; where the standard Cobb-Douglas assumptions are satisfied.
In the case of government outsourcing, the two parties could be an internal
government customer and external private contractor.31 Each player can also engage in
unproductive bargaining, bi. This influence and rent-seeking activity consists of measures
and counter-measures designed to preserve, capture or extract a larger share of the
surplus. While effort expands S for both parties in the transaction, bargaining determines the
share each player realizes. The combined costs of engaging in productive and unproductive
activities (to generate and capture the surplus respectively) are assumed to dilute the share
of surplus enjoyed by each player.
Player 1 chooses productive effort, e1, and unproductive bargaining, b1, to maximize
his utility function:
(2a) U1 =
[ 1/
2
σ σ
2 2
+ ( b 1 − b2
) − ( 1/
2)(
γ 1b1
+ β1e1
)] S
;
Similarly, player 2 chooses e2 and b2 to maximize her utility function:
(2b) U2 =
[ 1/
2
σ σ
2 2
+ ( b 2 − b1
) − ( 1/
2)(
γ 2b2
+ β2e2
)] S
.
The first two terms in brackets in (2a,b) represent the net benefit to each player
derived from bargaining over his share of the surplus, S. The last term represents the
quadratic costs to each player of engaging in unproductive bargaining activities and
productive efforts (respectively), as a share of S.
31 For instance, consider a government customer (or principal) that actively revises rules and regulations to allow
more economical or flexible procurement on the part of a private contractor (or agent). This productive effort
could lower the agent’s input costs, thereby contributing to joint savings or a surplus. Meanwhile, suppose the
agent simultaneously engages in productive investments in human capital or new processes that further
contribute to the surplus. “By exerting effort the [agent] can hold down its realized costs. For example, it can, at
some cost to itself, search for lower-priced raw materials…or it can manage its…inventories so that it is not left
holding excessive stocks” (McAfee & McMillan, 1988, p.17). The challenge remains how any gains, savings or
surpluses are shared between the principal and the agent.
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