Outside Contracts

We can apply our risk/reward structure to outside contracts. Imagine that your company hires another firm to construct a building. You can adopt one of three contracts, as noted below.^[2]

1. You pay the builder a fixed amount.

2. You pay him a fixed amount plus a percentage of any cost overruns.

3. You pay the total cost of construction.

The contractor obviously has the greatest incentive to minimize cost in the first contract. The first contract, also, puts the most risk on the contractor, so he would probably demand the higher fee under this arrangement.

^[2]See McMillan (1992), 95.