The design of a contract – the literal provisions that get written down to specify the product, frame the transaction, and govern the exchange relationship – impacts whether the contract delivers desired outcomes.  In federal contracting, fixed price contracts that assign cost and performance risks to suppliers are thought to benefit agencies, while suppliers are generally thought to prefer cost-reimbursement contracts that assign these risks to the purchaser.  Because agencies have become increasingly reliant on contracting to perform core tasks and functions, concern among overseers and policymakers grows about whether contracts deliver products that meet agency needs on time and within budget. In 2009, President Obama’s Office of Management and Budget guided federal agencies to increase their use of fixed price contracts.  In this paper we examine the prevalence of both fixed price and cost reimbursement contracts when markets are thin, that is when there are few buyers, sellers, or both.  The impact of contract failures (e.g. cost overruns) are likely to be greater in thin markets since buyers and sellers have few alternatives to turn to if things go awry with their current partner.  Based on our analysis of contract design in thin markets, we explore the managerial implications for government buyers when the market provides few alternative choices.

To assess the prevalence of different contract designs under different market conditions, we analyze a dataset of Department of Defense (DoD) contracts for 29 different types of products over a five year period (FY2004 – FY2008).  The DoD is the biggest purchaser in the federal government buying everything from simple products, like paper clips and grounds maintenance, to far more complex products, like advanced weapon systems and program management services.  Our dataset consists of over 2500 contract actions from the Federal Procurement Data System (FPDS).  We complement these contract design decisions with measures of product characteristics from an original survey of DoD contracting personnel and with measures of market conditions from a variety of sources.  The results of our empirical analyses show that the prevalence of cost reimbursement contracts is greater in thin markets than in thick markets; government purchasers generally bear more of the risk of cost overruns in thin markets than in thick markets.  These situations recommend investments in contract management capacity to reduce the likelihood of cost overruns.