A Note on Incentive Functions in Government Procurement Contracts

Government agencies use variants of the first-price sealed-bid auction mechanism to realize low cost, high quality, and on-time delivery when procuring goods and services. In a commonly used approach, agencies announce an incentive function that determines the amount they will pay based on the realized value of an attribute of the work performed, but bids do not explicitly include this attribute. The value of this attribute to the agency may be different in different situations. For example, in the procurement of transportation construction services, state transportation agencies make ex-post payments related to fuel or steel price escalation that have no value. They also make payments related to pavement density that have value because density is correlated with longer pavement life. This paper focuses on linear incentives and identifies situations in which an agency would benefit from incentives that favor high-cost high-quality contractors versus incentives that favor low-cost low-quality contractors. Although in this paper the procurement of transportation construction services is used as a motivating example, our results are applicable to a whole host of fixed price contracts in which extra payments are based either on changes in the price of a key input or the realized performance of the winning bidder on an attribute of value to the government.