Choosing the Sharing Rate for Incentive Contracts

Abstract

This paper analyzes the choice of the sharing rate in an incentive contract by a cost minimizing principal. Under an incentive contract, a principal pays some fraction of project costs (called the sharing rate) while the agent pays the rest. The main contribution of this work is that we are able to interpret the marginal conditions of the principal's choice of the sharing rate in terms of the equilibrium bid as a function of cost-and bid elasticities and project costs. We find that adverse outcomes from the principal's perspective arise when the bid elasticity is low and the cost elasticity is high. Using our results, a principal can predict the cost-minimizing bid before conducting an auction. The comparative static effect of a change in the exogenous number of bidders on the sharing rate is shown to depend on the market structure. Potential applications of these results are also discussed.