Criteria for contracting-out decisions when contractors can deceive

A decision rule is presented for contracting out that explicitly takes into account the possibility of contractor deception. In the model presented, the contracting agency opts to contract out only when the production savings exceeds the sum of its optimal monitoring expenses, optimal fine collection costs and the expected loss stemming from undetected cheating. Furthermore, in awarding contracts, the contracting agency explicitly takes into account the risk aversion of the contractor. The analysis suggests that effective contracts must consider the contractor's attitude toward risk and permit the contractor to retain some positive rent, conclusions that give rise to a number of non-intuitive policy implications.