What, no postings on the Nobel Prize? Is this list still functioning? ;-)
Now, on to the topic at hand:
Dan <[EMAIL PROTECTED]> writes:
> > Do you know of any studies of cost-plus financing, especially as used by
> > the US government in funding aerospace projects? I know this is one of
> > the main ways NASA funds its projects and it would seem to increase the
> > cost of any project.
This is actually in (what used to be) my line of work. Straight
cost-plus contracts -- in which the payment is realized (audited)
costs plus percentage of realized costs -- is no longer used by the
federal government (or at least, not by the Defense Department, and
I'm pretty sure not by NASA) and has not been used by them for several
decades. The potential for abuse is just too obvious. I think they
got rid of them during the McNamara reforms in the 1960s.
There is actually a veritable zoo of contract animals, with different
relationships between costs and payments. The closest to what you are
thinking of, currently in use, is called "Cost Plus Fixed Fee" (CPFF),
in which the government pays realized costs plus a fixed-in-advance
fee. The fixed fee is usually a percentage of the ESTIMATED costs,
not the realized costs. (There are serious incentive problems with
this, some of which lead to increased costs.)
There is also the "Cost Plus Incentive Fee" (CPIF) contract, in which
the government pays realized costs plus a fixed fee plus a percentage
of the difference between realized costs and estimated costs -- the
idea being that they want to give the contractor an incentive to
reduce costs, so they share some of the risk (i.e., let the contractor
keep some of the savings, and make him pay some of the over-runs).
There is a concise summary of the different contract types on pages
3-4 of my paper "Countervailing Incentives in Optimal Procurement
Auctions," which is here:
http://rbook.freeshell.org/Procurement_Auctions.pdf
Bill Sjostrom <[EMAIL PROTECTED]> responds:
> Cost plus is not obviously cost increasing. It passes on cost uncertainty
> to the buyer, who may be the lower cost risk bearer.
This is, indeed, the logic behind these contracts. But that does NOT
necessarily mean that they are not cost-increasing, because costs can
be manipulated by the seller in a way that is not observably different
from cost changes due to risk being resolved. In addition, the fact
that only a portion (sometimes none) of cost savings accrues to the
seller substantially blunts the sellers' incentive to reduce costs.
> This may particularly
> be true if there is uncertainty about the final product, that is to say, if
> the buyer wants changes during the course of the contract.
That's another problem. When the buyer wants changes, the seller can
often negotiate the cost upward by more than is truly justified by the
change, essentially loading cost over-runs from completed parts of the
project into the change order. This a HUGE -- and widely recognized
-- problem for the US military. The problem is that when you re-open
the negotiation for a complex product, it's extremely difficult to
observe whether the cost increases proposed by the seller are in fact
due to the changes requested by the buyer.
> Cost plus is a
> very simple contract to renegotiate.
Don't try telling that to a contracting officer! ;-)
Renegotiating these contracts is a full-time job for lots of people
(dozens to hundreds per ongoing contract). Of course, these are
government jobs, so they are probably not done efficiently -- but
still, if you have a complex product for which there is no market
price, a profit-seeking contractor, and any type of cost-dependent
contract, renegotiating and getting a "fair" price is going to be an
extremely complex task.
> On the other hand, it carries
> substantial enforcement costs, because production costs have to be verified.
It's true that there are substantial enforcement costs (auditing), but
that's not the real source of the problem. The problem is the way
auditing is done in the real world, and this would be a problem even
if auditors were free.
Auditors can (mostly) verify that a particular cost was incurred in
the production of a product, but they cannot verify whether that cost
OUGHT to have been incurred. For example, they can (in the ideal
world) verify that the CEO's golf membership wasn't included in the
cost of the aircraft carrier. But if the contractor decided to use
expensive titanium rivets when ordinary steel rivets would have been
just as good, the auditor will find the invoice for the titanium
rivets, verify that the titanium rivets went into the ship, and
approve the expense -- even if the contractor just switched to
titanium rivets because there is some way he can get extra money
beyond the extra cost of the rivets by using them. (Example below.)
Since a lot of these contracts are "repeated games," there are all
sorts of manipulations that are possible. For example, US Navy shi
