Abstract

A chief objective of creating competition among suppliers is the procurement of higher quality goods and services at lower prices. When procuring non-standard goods, it is often difficult to write a complete specification of desired quality in the contract. A moral hazard arises when this quality is costly and determined by the supplier ex post to contracting. In an effort to mitigate this moral hazard, we introduce a correlated contingent payment contract. This contract is awarded through competitive bidding. The winning supplier’s payment is, according to a fixed probability, either the amount of their bid or a quality contingent amount that depends on the bid and an exogenous norm for how a seller and buyer split social surplus. We show, both theoretically and experimentally, there is a “Goldilocks” region for high quality to emerge in which the probability of quality contingent payment is large enough to reward high quality provision, but not too large to induce overly aggressive bidding. This optimal implementation only relies upon preferences for maximizing one’s own profit and the rationality of backward induction. A surprising experimental result is that suppliers earned positive economic profits within this region. We estimate a structural model of bounded rationality to show that risk aversion can explain this result. These results have managerial implications for the design of contingent payments in contracts.