IT Outsourcing; Gain-share Contract; Cost-plus Contract; Joint Product Improvement; Double-sided Moral Hazard;
The authors study the role of different contract types in coordinating the joint product improvement effort of a client and a customer support center. The customer support center's costly efforts at joint product improvement include transcribing and analyzing customer feedback, analyzing market trends, and investing in product design.Yet this cooperative role must be adequately incentivized by the client, since it could lead to fewer service requests and hence lower revenues for the customer support center. The authors model this problem as a sequential game with double-sided moral hazard in a principal-agent framework (in which the client is the principal).The authors follow the contracting literature in modeling the effort of the customer support center, which is the first mover, as either unobservable or observable; in either case, the efforts are unverifiable and so cannot be contracted on directly.The authors show that it is optimal for the client to offer the customer support center a linear gain-share contract when efforts are unobservable, even though it can yield only the second-best solution for the client.The authors also show that the cost-plus contracts widely used in practice do not obtain the optimal solution. However, the authors demonstrate that if efforts are observable then a gain-share and cost-plus options- based contract is optimal and will also yield the first-best solution.Their research provides a systematic theoretical framework that accounts for the prevalence of gain-share contracts in the IT industry's joint improvement efforts, and it provides guiding principles for understanding the increased role for customer support centers in product improvement.