Firms J and K are competing to supply high-tech equipment to a government buyer. Firm J’s expected production cost is $105 million, and its profit requirement (on top of this) is $5 million. (The firm demands this profit because it can earn this amount on a comparable contract.) Firm K has an expected cost of $95 million and a profit requirement of $7 million. The government buyer has limited information about the firms, so it does not know which has the lower total cost (direct cost plus profit).
a. Suppose the government stipulates a cost-plus contract and plans to choose the firm that submits the lower-profit bid. Which firm will it select? Is the selection process efficient?
b. Suppose, instead, that the government sets a fixed-price contract, and the firms submit total cost bids. Which firm will be selected? Why might firms insist on a higher required profit under a fixed-price contract than under a cost-plus contract?
c. Finally, suppose the government uses an incentive contract and sets the firm’s sharing rate at b = .25 and the cost target at cT = 100. Which firm can be expected to submit the lower required-profit bid? Will the efficient firm be selected?