Trust and Trustworthiness in Procurement Contracts with Retainage

Abstract

In complex procurement projects, it is difficult to write enforceable contracts that condition price upon quality. Supplier nonperformance becomes an acute risk, particularly when there is intense competition for the contract. An established incentive mechanism used to mitigate the problem of supplier nonperformance is retainage, in which the buyer sets aside a portion of the purchase price. After project completion, the buyer determines the amount of retainage that is released to the seller, considering any defects that arise. Although generally a feasible contract form to implement, the practical difficulties in assessing completion introduce a moral hazard for the buyer. We develop a structurally new game and experimental design to offer managerial insights on how retainage principles mediate trust and trustworthiness in competitive procurement settings with moral hazard. The experimental results suggest that if trust in the procurement relationship is strong enough, then retainage can mitigate the seller-side moral hazard problem and substitute for reputation in a fragmented supply chain at the cost of inflated tender prices. In high retainage structures, there is a tradeoff between trade efficiency and supplier participation in request for bids. We further develop a model of fair payment norms and offer managerial insights on how to design the retainage mechanism, conditional on prevailing levels of trust and beliefs about fairness. This paper was accepted by Vishal Gaur, operations management.

Manufacturer’s Incentive Strategies in a Dual-Channel Supply Chain with Moral Hazard: A Long-Term Perspective

“…and Martimort, D. [17] analyzed moral hazard in detail from the principal-agent view. The authors of [21,[28][29][30] analyzed the design of contracts when single moral hazard existed in supply chains. Moreover, refs.…”

“…In summary, to the best of our knowledge, a large body of existing literature on moral hazard in supply chains has focused on the design of incentive contracts in single-channel supply chains within a one-period time horizon [16,19,21,22,28]. However, in practice, with the fast development of e-commerce, supply chains with both online and offline channels are more common and popular in operations.…”

“…Although some researchers have investigated the moral hazard problem in singlechannel supply chains [16,[19][20][21][22], little work has been conducted regarding multi-period strategies in the structure of dual channels. In practice, cooperation between manufacturers and retailers often occurs for more than one period.…”

Bilateral communication in procurement auctions

“…Cox et al (1996) and Onderstal and Van de Meerendonk (2009) focus on auctions of incentive contracts in settings with moral hazard. Auctions of fixed‐price contracts with moral hazard have been studied by Brosig‐Koch and Heinrich (2014, 2018), Fugger et al (2019), Walker, Katok, and Shachat (2023), and Walker, Shachat, and Wei (2023). Another common practice in case not all information is available when conducting the auction is to make it possible to renegotiate terms after the seller selection.…”