Double-sided Moral Hazard; Performance-based Contracts; Financial Distress; Machine Repairman Model ;
Outsourcing of equipment repair and restoration is commonly practiced by firms in many industries. The operational performance of equipment is determined by joint decisions of the firm (client) and the service provider (vendor). Although some decisions are verifiable and thus directly contractible, many decisions are not. The result is a double sided moral hazard environment in which each party has incentives to free-ride on the other’s effort.A performance-based contract allows the client to align the incentives of the vendor, but it also exposes the vendor to stochastic earnings and thereby creates disincentives to make first-best decisions. To capture these issues, we develop a novel principal–agent model by integrating elements of the machine repairman model and a stochastic financial distress model within the double-sided moral hazard framework.The authors apply our model to solve the client’s problem of designing the optimal performance-based contract. They find that the client can attain the first-best profit by restricting the search space to only two classes of performance-based contract structures: linear and tiered.The authors show that the linear contract structure has limited ability in attaining the first-best outcome, contingent on the vendor’s exogenous characteristics. In contrast, the tiered contract structure enables the client to attain the first-best outcome regardless of vendor characteristics. Our results provide normative insights on the role of contract structures in eliminating any loss due to double-sided moral hazard or to the vendor’s financial concerns.These results also provide theoretical support for the extensive use of tiered contracts observed in practice.