THE THEORY OF CONTRACTUAL INCENTIVES

FOR COST REDUCTION*

F. M . SCHEEEB

I. The basic contract types, 268.—II. The contractor's profit

tion problem, 261.—III. Outlay minimisation by the government as buyer,
271.—IV. Consistency with empirical evidence, 273.—V. Toward a theoiy
of risk aversion, 276.—VI. Some broader implications, 278.

Defense contracting differs in many respects from more con-

ventional economic activities, and consequently a study of defense
contracting affords an opportunity to explore tiieoretically and em-
pirically aome behavioral hypotheaea we normally either take for
granted or aaaume to be unteatable. One major difference ia the
cost-plus character of defenae contract pricing. At leaat in the
advanced weapona aector, which accounta for more than half of all
defense procurement outiaya, pricea are generally negotiated bi-
laterally in aome more or leaa fixed relationahip to an eatimate of
actual coata, rather tiian being aet by the play of competitive
market forcea. In the fiacal year 1962 60.6 per cent by dollar
volume of all defenae contracta waa written without any aort of
direct price competition, and in only 17.1 per cent were pricea aet
through aome kind of advertiaed competitive bidding.^ A aecond
difference ia the wide variety of contract typea employed, providing
widely varying degreea of financial risk assumption by the con-
tractor. Variations in the degree of financial risk aaaumption lie
at the heart of the contractual incentivea problem. Thia article
deals with the optimal choice of risk assumption provisions from
the viewpoints of both the contractor and the buyer, given aome
negotiated eatimate of coats to be incurred. Although apace limita-
tiona and inherent difficultiea preclude preaenting a complete theoiy
of contractual incentives, it will be possible to illustrate the most
important general problema and to auggest further analytical and
empirical work.'

* The research underlying this paper was supported by a Ford Foundation

grant to the Harvard University Weapons Acquisition Research Project. I am
also indebted to Richard Henebower, M. J. Peck, and Arthur Smithies for
valuable suggestions.
1. OflSce of the Secretary of Defense, Military Prime Contract Award*
and Subcontract Paymenta, July 1961-June 1962, pp. 28-30.
2. Some of the issues in this paper are explored more fully in F. M.
Scherer, The Weapona Aeguintian Proeeaa: Eeanomie IncenUvea (Boston:
258 QUARTERLY JOURNAL OF ECONOMICS

I. T H E BASIC CONTRACT TYPES

Let us begin by distinguishing two polar contract types used

in defense contracting. At one extreme is the firm fixed price
(FFP) contract, which corresponds most closely to the contractual
relationship prevailing in more normal economic activities. With
it the contractor promises to supply certain specified goods or ser-
vices at a price which, after agreed upon by buyer and seller, is
not subject to adjustments refiecting actual cost experience. Profit
is then the residuum of price less cost. For every dollar of cost
reduction the contractor's contract profit is increased a dollar, and
so a clear incentive for cost efficiency is established." At the oppo-
site extreme is the cost-plus-fixed-fee (CPFF) contract. With it
buyer and seller initially agree upon a fee or profit amount based
upon an estimate of total costs. The cost estimate is not binding;
the buyer agrees to reimburse within limits all legally-allowable
costs incurred by the contractor in executing the contract. Thus,
the "price" in a CPFF relationship is almost completely fiexible.
The fee, however, is fixed. Barring a change in contract performance
requirements, it can be neither decreased nor increased, whether
actual costs prove to be greater or less than the initial estimate.
For this reason it is often said that the CPFF contract provides no
incentive for cost reduction and efficiency. We shall see that this
belief is erroneous, but certainly the CPFF contract creates a
weaker incentive than the FFP contract.
All the financial risk of deviations in actual cost from the
negotiated cost estimate is assumed by the contractor under a FFP
contract and by the government as buyer under a CPFF contract.
In this sense the two contract types are polar altematives. To fill
the gap between these two poles, the so-called cost incentive con-
tracts have been devised.* With such contracts, variations in

Division of Research, Harvsrd Graduate School of Business Administration,

1964).
3. The effect of corporate income taxes is largely ignored in this article.
4. There are two main types of cost incentive contracts—fixed price
incentive (FPI) and cost-plus-incentive-fee (CPIF) — differing mainly in the
treatment of cost overruns be}rond some ceiling or undemms below some fioor.
With a FPI contract the contractor assumes finandal responsLbilily for all
costs incurred above sonie cdling, while with a CPIF contract the government
assumes this responsibility. The existence of ceilings and floors is ignored
in this article. This is not an unduly restrictive simplification, for at least
on FPI production contracts^ ceilings and floors have rarely beai penetrated.
Recently, CPIF contracts have been written with incentive provisions
applicable not only to cost dimension performance, but also to performance
of development contrectora in meeting time and quality targets. The theoiy
of these multidimensional incentive contracts cannot be explored here. But
 THE THEORY OF CONTRACTUAL INCENTIVES 259

actual costs from the originally negotiated estimate are shared by

the buyer and sdler. Initially a cost target, a target profit, and a
sharing formula are negotiated. If, for example, the contractor's
share is a constant 20 per cent and actual audited costs tum out to
be $1 million less than the target cost, $200,000 is added to the
contractor's target profit, the remaining $800,000 reverting to the
govemment. Conversely, if actual costs prove to be higher than
the target cost, the contractor's profit is reduced by 20 per cent
of the excess, the govemment reimbursing the balance.
This incentive contract arrangement can be formulated alge-
braically. Let ni> be the negotiated target profit amount, a (alpha) the
contractor's constant sharing proportion, CT the negotiated target
cost, and CA the actual cost charged to the contract. Then the
contractor's realized contract profit Ug is determined by the linear
equation:
(1) Uc = nT-i-a{CT-CA).
Linearity is of course not essential, but in practice continuous linear
incentive formulas have been employed almost universally, at least
within limits assumed here not to be restrictive. To dmplify the
expodtion, it is convenienttolet:
(2) X = CT-CA,
where a positive value of X indicates a contract cost undermn
(actual costs less tiian the target cost) and a negative value a
so-called cost overmn (actual costs greater than the target cost).
It is also convenient to let Cr = 100, pennitting all other magnitudes
to be expressed, as in common practice, as a percentage of target
cost. Substituting (2) into (1), we obtain the bade rdationship:
(3) Ho = nj. -I- aX.
These three equations have two different interpretations. In
normal practice, Cp is set by negotiation before any work is done
under the contract. The cost target may be "optimistic" and "tight"
if the govemment has the upper hand in bargaining (i.e., when
see Scherer, op. cA., Chap. 7; and N. S. Weiner, "Multiple Incentive Fee
Maximisation: An Economic Model," this Journal. LXXVII (Nov. 1963).
Weiner's analysis makes the assumption that contracton always minimise tiie
cost of any particular time-quality outcome — an assumption to be questioned
in the a n a l i s presented here.
Certain other contract typea used in defense procurement to encoursge
cost reduction while limiting the contractor's financial ride niust also be
ignored. Notably, the redeterminable fixed price contract limits risk by delay-
ing agreement on a firm fixed price until some cost experience in executing
the contract has been accumulated, while the fixed price escalation contract
relates the ultimate contract price in part to the values of relevant labor
and materials cost indices.
260 QUARTERLY JOURNAL OF ECONOMICS

strong competition from direct or indirect substitutes exists) or

"pessimistic" and "loose" when the contractor has a bargaining
advantage. But in any case, CT has a known fixed value ex ante
as well as ex post. The situation is different with CA and hence X.
After contract completion, CA and hence X have unique known
values (overlooking possible arguments over certain accounting cost
allocations). But before contract execution, this is not so. The
ex post value of CA depends upon two thinp: the decisions the
contractor takes as to how vigorously and how far to extend its
cost reduction efforts, and the outcome of various initially uncertain
contingencies affecting actual costs. This article is concemed with
the contractor's cost reduction decision-making problem; that is,
with the first element upon which CA depends. The second element
—the degree of uncertainty present — is assumed to be beyond the
contractor's control." Recognizing the presence of uncertainty, the
contractor is provisionally assumed to make its decisions in terms,
say, of expected values. Therefore, from an ex ante point of view
we may rewrite (3):
(4) E(na) =IlT + aE{X).
The primary economic difference between FFP, CPFF, and cost
incentive contracts lies in the value of the contractor's sharing
proportion a. With a CPFF contract a = 0 and only the fixed fee
Ilr can be achieved; with a FFP contract a = 1.0; and with a cost
incentive contract a takes on values intermediate between 0 and 1.0.
The problem explored here is that of choosing an optimal a, given
various assumptions about CT and E{CA) (and hence E{X)) and

It is customaiy for the govemment to award a higher nego-

tiated target profit UT to contractors who bear a relatively high
financial risk — that is, who accept relatively high values of a —
than to those who bear a smaller risk. Although other factors also
affect the value of Hi> negotiated, when they are held constant Ilr
tends to be a monotonically increasing function of the sharing pro-
portion a chosen. For simplicity we shall assume Hr to be a quad-
ratic function of a:
(5) UT = nr(a) =k-[-ha + me?.
5. For an examination of the uncertainties which pervade weapons
development and production, see M. J. Peck and F. M. Sdierer, The Weapons
AcquisUion Process: An Economic Analysis (Boston: Division of Researeh,
Harvard University Graduate School of Business Administration, 1962), pp.
17-^; and A. W. Marshall and W. H. Meckling, "Predictability of Cost, Time
and Success of Development," The Rate and Direction of Inventive Activity,
National Bureau of Economic Researeh Conference Report (Princeton:
Princeton University PresB, 1962), pp. 461-75.
 THE THEORY OF CONTRACTUAL INCENTIVES 261

Empirical evidence suggests that on the average, k is equal to

roughly 6 (that is, the fixed fee on a CPFF conixact, with a = 0,
averages 6 per cent of target cost). Ilr tends to reach a manmum
of about 12 with FFP contracts (a = 1.0). The rate at which Ur
increaaea from 6 to 12 on varioua incentive contracta with inter-
mediate degreea of financial riak aaaumption by the contractor
obviously dependa upon the valuea of h and m. For (6) to be
monotonically increaaing up to a = 1.0, it ia alao necessary that:
(6) -^^= h-\-2ma> 0;a
da
which is aatiafied only when
(7) -h<2m.

II. T H S CONTBACTOE'S PROFIT MAXIMIZATION PEOELBM

Given theae baaic relationahipa, let ua conaider the contractor'a
choice problem. We begin with tiie aimpleat poaaible caae, building
to more complex variations. Assume that the contractor seeks to
maximize the expected value of its contract profit E (Ho) under the
belief that ihe contract's actual cost outcome will have the specific,
unique expected value E{X). Substituting (6) into (4), the con-
tractor aeeka to maximize:
(8) E{Uo) = A; + ^ + ma' + aE{X).
Firat and aecond order conditiona for a local maximum are:
(9)
da

dtr
It ia clear from (10) that a local maximum exiata only when m ia
negative; that ia, when target profit Ilr ia increaaed with increaaea
in a at a diminiahing rate. Otherwiae a comer aolution will prevail
— the contractor'a choice will polarize toward either FFP (a =
1.0) or CPFF (a = 0) contractual coverage. From conatraint (7)
and from the inatitutional constraint that a cannot exceed the 1.0
value of a FFP contract, it can be shown that valuea of a inter-
mediate between 0 and 1.0 (ao-called incentive contracta) are
optimal only when £ ( X ) ia moderately negative; e.g., when a
modeat coat overrun ia anticipated. Conversely, a contractor expect-
ing a coat underrun would alwaya maximize the expected value
262 QUARTERLY JOURNAL OF ECONOMICS

of its profits by choosing FFP contractual coverage, benefiting from

both the maximum Ilf and the maximum share of the cost undernin
retained as profit.
If, as assumed in this first case, the contract's expected cost
outcome is anticipated as a unique value before a is chosen, differ-
ences in a must have no cost incentive effect on the contractor's
behavior. But such a case appears unrealistic. Rather, we should
expect E{X) to depend to some extent on the value of a chosen.
Presumably, the higher a, the stranger the cost reduction incentive
will be, and therefore the greater the actual X will tum out to be.
This is an intuitively appealing and even obvious assumption, but
to the best of my knowledge, its theoretical implications have never
been explicitly identified. If changes in the value of a do have
incentive effects on contractar cost reduction behavior, there must
be some function related to E {X) which offsets the incentive profits
attainable by increasing E(X). Two such functions have been
observed in weapons contracting, and could probably be encountered
in most production activities. Cost reduction gives rise to mana-
gerial disutilities, and it gives rise to user costs. Here only a user
cost function will be employed in the basic model in order to
maintain a provisional expected profit maximisation assumption.
The concept of user cost was introduced by Keynes, but in this
article a rather different type of user cost is considered." User
costs, as defined here, reflect the expected future profit sacrifices
resulting from current contract cost reduction effarts which yield
expected current accounting profit increments. Specifically, in the
development or production of a weapon system, reductions in current
costs can often be achieved only by cutting corners on quality;
letting time schedules slip; or eliminating personnel, equipment, and
research projects which, if retained, would enhance the firm's future
competitive position.'' Let the contractor's estimate of the relation-
ship between E{X) and sales in year t be:
(11) AS, = S , [ S ( X ) ] ,
where AiSt is defined as the total amount of sales expected to be
sacrificed (or if it is negative, gained) as a result of increases (or
6. J. M. Keynes, The General Theory of Employment, Interest and
Money (New York: Harcourt, Brace, 1936), pp. 53 and 66-73. For further
and varied applications of the user cost concept, see Alfred C. Neal, Indiutrial
Concentration and Price Infiexibility (Wauington: American Council on
Public Affairs, 1942), pp. 70-«9; P. T. Bauer, "Notes on Cost," Economica,
NS., XII (May 1945), pp. 90-97; and A. D. Scott, "Notes on User Cost,"
Economic Journal, LXIII (June 1953), pp. 368-84.
7. Empirical support for this statement is provided in Scherer, op. cU.,
Chap. 2, 3, 4, and 7.
 THE THEORY OF CONTRACTUAL INCENTIVES 263

decreases) in E{X) due to decreases (or increases) in E(CA).'

Associated with t^is anticipated sales loss in year t is an anticipated
profit margin P{t) on year t'a sales. Considering all T -f-1 yeara
in which sales sacrifices might occur, total user cost U[E{X)]
is defined aa:
T
(12) '^
.-c [! + '•]'
where r is an appropriate discount rate.
The user cost function's general configuration can be deduced
on a priori grounds. (Dommon sense dictates that in reducing costs,
a firm will exploit first those cost reduction opportunities which
have the least adverse impact on expected future sales and profits
(or in terms of a disutility analysis, which are least unpleasant)
and leave until last those which have the most adverse impact. The
first cost reduction opportunities exploited will undoubtedly enhance
the flrm's future sales and proflts by improving the program's
competitive position and perhaps even averting premature program
cancellation due to exceaaive costs.' But as the coat reduction effort
is carried further, the firm must eventually be faced only with
cost reduction opportunities which involve future sales and profit
sacrifices. For example, costs can be cut by reducing product
quality, but quality sacrifices usually precipitate the loss of sales
to substitute products. And in the institutional environment of
defense contracting, personnel layoffs often impair a firm's chances
of winning new contracts, for the possession of a seasoned technical
and production staff ia weighted heavily when the armed services
select contractors for new programs. Indeed, this emphasis on the
availability of manpower encourages defense contractors to hoard
personnel and maintain their work forces at inefficiently high levels.^
Assuming then that very many cost reduction opportunities are
ordered in this way for potential exploitation, we can see that the
firm's user cost function V[E{X)] must be U-shaped. It is not
too severe an abstraction from reality to aasume also that the func-
tion is smooth.

8. Obviously, this estimate is subject to substantial uncertainties. For

a more complex stochastic treatment, see Scherer, op. dt., Appoidix to Chap. 7.
9. These first acticnis may be so obviously attractive that tbe firm does
not even think of them in terms of a cost reduction decision-making problem.
As in most economic problems, it is actions at the margin which are of
crucial interest.
1. For emi»rical support, see Scherer, op. eit.. Chap. 4.
264 QUARTERLY JOURNAL OF ECONOMICS

The simplest function which meets these specifications is the

quadratic relationship:
(13) U[E{X)]=a + bE{X)-i-c[E{X)]'
where c is necessarily positive. Following the principle of Occam's
razor, this quadratic form will be employed here. The empirically
insignificant loss of generality from this convention is more than
compensated by the greater lucidity and ease of manipulation.' It
is further assumed that the constant term a = 0. This specifica-
tion has two justifications. First, once the contractor has decided
that it will execute the contract, a is irrelevant in determining either
X or a, at least in a first approximation to the theory. Second,
letting a = 0 is consistent with the inherentiy relativistic, action-
oriented nature of the user cost concept. User costs are incurred
only by moving from some given position. In this model the cali-
bration point is taken to be letting expected actual costs neither
undermn nor overmn the cost target, so tiiat E{X) = 0. For this
calibration case user cost shauld be zero, which occurs only if a = 0.
Thus, only the parameters b and c are of interest. The value of c
governs the breadth of the "U". The higher c is, the less difference
there will be between the optimal expected cost outcomes of CFFF
and FFP contracts. Casual observation suggests an average value
of c on the order of .05 when CT = 100; that is, costs under a FFP
contract probably tend to be about 10 per cent lower than under
a CPFF contract. The value of b depends upon the contract cost
target negotiations. As we shall see more clearly in a moment, the
"tighter" the cost target set, the higher b will be.
Given the existence of a user cost function and a negotiated
cost target, the contractor has a two-stage long-run profit maximiza-
tion problem. First, an optimal a must be chosen in contract
negotiations. Then given a, the contractor must carry its cost
reduction efforts just far enough to expect the optimal value E{X)
to result from actual contract execution. It is convenient to antici-
pate solution of the second maximization problem first. To maxi-
mize expected long-mn profit E{Ilut), the contractor should maxi-
mize the following expression:

2. Note tbat £ [ l / ( X ) ] is not tbe same as U[£(X)] wben tbe user cost
relationsbip is nonlinear. If tbe user cost function is increasing at an in-
creasing rate tbroughout tbe range of ponible values of X, as seems normally
to be the case, EUHX)i would toid to exceed l / [ £ ( X ) ] . Tbe UVHX)l
expression is employed bere because future sales probably depend more upon
deonite cost reduction efforts wbieb sbift tbe wnole diatribudcn of posnble
cost outcomes, of wbicb E(X) is tbe mean, than on cbance variations in tbe
realised value of X.
 THB THBORY OF CONTRACTUAL INCENTIVES 265

(14) E{VL^) = nr-|-«B(Z) - V[E(X)]

= UT-\- aE{X) -bE{X) -
where, since a is predetermined in negotiations, Ilr is also a pre-
determined constant. Differentiating with respect to E(X), we
obtain as a first order condition:
(16)

When c is positive the second derivative is negative, and so a local

maximum exists. Solving (15) for E{X) in terms of a, b, and c,
we find that:
(16) E{XUf = ^!^.

Three properties of this result are of immediate interest. First,

for any allowable values of b and c, E{X)e^ reaches its maximum
value when a has its maximum value of 1.0, under afirmfixedprice
contract. Any lower value of a — e.g., the zero value of a CFFF
contract — will lead to a smaller optimal E {X); that is, to a smaller
expected undermn or a larger expected overmn. Second, the higher
the value of b for any given values of a and c, the smaller EiX)art
will be. When b > 1.0, E{X)^ < 0. An expected cost overrun
will be optimal, since a cannot exceed 1.0. Thus, when a contractor
executive complains, "The govemment really drove a hard bargain
on this contract," he is in effect saying that the value of b is relativdy
high. Third, even when a = 0 under a CFFF contract, it cannot
be said that the contractor has no incentive for cost reduction.
The contractor dearly has an incentive to limit E{X) to that value
at which it equals -^^—.
2c
These findings are illustrated in Figures Ia and Ib. In Figure
Ia, assuming that V[E(X)] = J5E(X) -\- .05[£(X)]*, the optimal
E{X) for a = 1.0 is -I- 6.0 — an expected undermn of five pe>
centage points. The area OCB shows the expected incentive profit
aE{X) anticipated in this firm fixed price case. When a = 0 under
a cost-plus-fixed-fee contract, the optimal E(X) is —6.0 — an
overmn. If contract cost targets are negotiated so tightly that
b = 1.4, as in Figure Ib, the optimal E(X) when a = 1.0 is —4.0
— an overmn, despite the FFP coverage. The expected overmn is
even larger—S(Z)^, = -14.0 —when CPFF coverage is em-
plqyed.
In contract negotiations, the contractor's long-run prefit nuud-
266 QUARTERLY JOURNAL OF ECONOMICS

10 10
8 / 8 /
6 6 /
c / 4 • /
4 • ^,y(k' 1.0
Z /

S^ 0 . . . . . . . . 0/ . •

2 4 6 8 IOE(X) -16-14-12-10-8-6 -4 - 2 / 2 4 EM
(l>0 -2
-4
-6
-S
' ""^ -10
-10

Figure Ia Figure Ib

mization problem is somewhat more complex, since a and nj>(a)

are not predetermined.' The contractor must attempt to obtain
that value of a which maximizes:
(17) £(nijt) = nr + aE{X) - V\E{X)\ = fc -|- ^
mtc -f- tu!i\A.) — oti\A.) —

Substituting in (16) for E{X), we obtain:

(18)

2c 2c
Differentiating, we obtain as a first order condition:
(19) --A-— 2 { +— =0.
do~~ 2c °^*" 4c
The second derivative is:
1
(20)
"* "2c"'
which must be negative for a local maximum. The second term of
(20) cannot be negative, since for a U-shaped user cost function
it is necessaiy that c be positive. Therefore, for a local maximum,
m must be negative. This result is similar to that obtained in con-
3. It is assumed here that tbe cost target CT is already negotiated and
tJierefore predetermined. Tbis assumption doiss some violence to reality, since
in fact CT and a are generally negotiated simultaneously, and cbanges in one
often lead to changes in the otber during tbe s v e and take of bargaining.
But it remains true tbat for any given terminal Ct bargain, there is generally
a unique optimal a for the contractor.
 THE THEORY OF CONTRACTUAL INCENTIVES 267

nection with the simpler case explored in (8) through (10). Intui-
tively, the target profit risk premium function ni>(a) must be con-
cave to the a axis, target profit being increased with increases in a
at a diminishing rate. In addition, the following inequality must
be satisfied:
(21) m < - l - .
4c
When c is fairly small, the combination of constraints (7) and (21)
can be quite restrictive. If the necessary conditions are not satisfied,
the contractor's a preferences will polarize about either a = 0 (a
CPFF contract) or a = 1.0 (a FPP contract). Consequently, from
the analysis thus far, we should expect values of a intermediate be-
tween 0 and 1.0 (that is, incentive contract coverage) only in
special cases.
It can be shown further that intermediate values of a are optimal
under the present assumptions only in expected overrun situations.
Here an intuitive explanation must suffice.'* If an undermn is at
all attractive to the contractor, the slope b of the user cost function
a,iE(,X) = 0 must be less than some attainable value of a. If this
were not so, (a — b) in (16) would be negative, and so E(X) would
also be negative at the optimum. Let us suppose that b = .20.
Then an expected undermn would be optimal only if a > .20. But
if the contractor is going to undermn at all, it would maximize the
expected value of its profits by going all the way to a = 1.0. This
is so for three reasons. First, the contractor can get a higher nego-
tiated profit rate by going from, say, a = .30 to a = 1.0. Second, at
a = 1.0 the contractor retains the largest possible share of its ex-
pected undermn. And third, with a = 1.0 the contractor will find
it optimal to achieve a larger undermn than with any lower value
of a, and so it will have a larger expected cost saving to retain as
profit. Only on the expected overmn side may a < 1.0 begin to
look attractive.
We find therefore that under the assumptions made thus far,
the choice of so-called incentive contracts, with 0 < a < 1.0, is
optimal for an expected profit-maximizing contractor only in cer-
tain very special cases: when a modest cost overrun is desirable
and when the nr(a) function has a special concave configuration.
But one complication more or less unique to defense contracting
can alter this finding. "Profiteering" at the expense of national

4. A more rigorous proof is provided in Scherer, op. dt.. Appendix to

Chap. 8.
268 QUARTERLY JOURNAL OF ECONOMICS

defense agencies haa an especially odious connotation, and several

checks exist to limit defense contract proflts. High contract proflts
Ilof due to a substantial cost underrun may be recouped througli
statutory renegotiation or throu^ informal pressures exerted by
service procurement agencies, the General Accounting Office, and
Congress. Some insight into the problem can be gained by making
a simple constraint assumption — that all contract profits Ho = nr
+ aX greater than aome ceiling iS muat be refunded to the govem-
ment, where iS in practice would tend to have a value on the order
of 12 to 16 when CT = 100." Then situations may arise in which
an expected underrun is optimal under the foregoing criteria (that
is, when b < 1.0) and the maximum retainable He could be realized
with values of a less than 1.0 aa well as with a = 1.0. What value
of a should the contractor choose then?
At least four cases can be distinguished. First, with a user
cost function monotonically increasing over all values of E{X) > 0,
flrm fixed price coverage will alwaya be optimal if the contractor
knows with certainty the actual value of X which will result from
ita cost reduction efforts. This is so because with FFP coverage
the constrained maximum i8 for IIo is achieved with the smallest
possible underrun, and hence the minimum user coat. And when
Ho ia firmly constrained at ita limit S, long-run profit is maximized
by minimizing uaer cost.
Second, the result ia altered when an element of technological
uncertainty with reapect to the actual value of X exiats. The prob-
lem also becomes much more complex, and it is possible here to
auggeat only the direction of the change. Suppoae the contractor
proviaionally chooses flrm fixed price coverage and plans to
operate in such a way as to aet the expected coat outcome E(X)
(rather than the value of X known witii certainty, as in the first
caae) at that level which will equate the contract profit expected
before renegotiation [that is, Tlr + aE[X)] with the constraint S.
Now as a result of uncertainty the actual value of X ia likely to
deviate either above or below E{X) in a manner beyond the con-
tractor's control, and so the actual He will deviate above or below
B. This is clearly an oversimplification. In fact, it is generally possible
to retain higher profits when hi^er values of a u e accepted. In a more
complete analysis the constraint S would be an increasing function of a.
It should also be noted that under the letter of the law, statutory renegotiation
deals only with a company's overall annual profits, and not with profits on
specific contracts. But in practice the Renegciiation Board psys considerable
attention to particular contracts yielding especially high profits, and althorugh
such profits might be offset by low profits on oUier contiacts, there is a
tendency for refunds to be required. GAO investigations of a l l i e d profiteering
almost a l w i ^ focus on Bpecmc contiaets.
 THE THEORY OF CONTRACTUAL INCENTIVES 260

Ilr + aEiX) unless a = 0. Let the deviation of X from E{X) he i.

More precisely, let
(22) i = X-E(X).
If nr -I- aE{X) = S, no incentive profits aS can be retained for any
positive j ; they will berecapturedin renegotiation or its equivalent.
The best the contractor can do is to retain actual contract profits
of S, which will occur when 3 = 0 under the conditions assumed
thus far. But when 8 is negative, the contractor will fail to reach
tiie profit ceiling of S. Assume that the 8's are normally distributed
with the prior subjective density function f{i\E {X), o^). Then the
expected value of the deviations of Ho from Hr + aE{X) will be:
X-B(X)—O
I -_i
/
8 6 a^ d8.
— <fV2»-
If a isfixedand the contractor sets E {X) so as to make Ilr -|- a& (X)
= S with a = 1.0, the integral portion of (23) is a constant.' As a
first approximation, the contractor would like to alter its initial plan
in such a way as to make the absolute value of (23), representing
the expected value of the possible deviations of Ho from its con-
strained ceiling S, as small as possible.. There are two not mutually
exclusive ways of doing this: increasing E{X) so that the upper
limit of integration in (23) falls below zero, or. decreasing a from
the initially planned value of 1.0 toward zero. If a is held at 1.0
and E(,X) is increased, (23) will be reduced. But as E{X) is
increased V[E(X)] will rise. Before (23) is reduced to zero the
dUlEiX)]
pomt may be reached at which -• equals the marginal
dE{X)
addition to expected contract profits (1.0)/[Z -E(X)], and fur-
ther increases in E{X) will be unprofitable. Further reductions in
(23) must be achieved by reducing a, which from the point where
dU[E(X)]
—7=^7^= (1.0)f[X-E(X)] requires a decrease in E{X).
dE[X)
Altematively, the contractor might begin moving from the initially
6. Eminrical studies auggeat that weapona production contract coat out-
come prediction errors are normally dLstributed with a standard deviation of
roughqr 10 percentage points. When r = 10, the integral in (23) has a value
of approximately 4 JS. However, tiie estimate v = 10 undoubtedly overstates
the amount of purely technological uncertainty faced by production con-
tractoFS. Actual cost outcomes departed from negotiated taigets not only
because of random deviations attributable to technological uncertainly, but
also because of deviations in relative bargaining power in the target-setting
process and in tiie non-uniform inddence of incentive effects.
270 QUARTERLY JOURNAL OF ECONOMICS

planned position by reducing a. To maintain UT + aE {X) at the

initially planned value of S, this requires that E{X) be increased,
which again implies rising user costs. As a is decreased and E (X)
dU[E(,X)]
is increased, will eventually equal af[X — E{X)].
dE{X)
Any further reduction in a will be compatible only with a reduction
in E{X), and the plan to hold UT + aE{X) = S must give way,
with UT + aE(X) falling below S. Since small positive values of
aS can then be retained as UT-\- aE{X) falls below S, the upper
limit of integration in (23) increases and possible random positive
increments of incentive profit aB begin to offset the negative incre-
ments. In fact, some complex combination of both these reactions
to the profit constraint will probably occur, the process eventually
being damped by increases in user cost as E(X) is increased, or
by decreases in expected contract profits due to a falling ni<(a) and
a falling a effect on X as a is reduced.''
We see then that one likely effect of renegotiation when actual
cost outcomes can be predicted only subject to uncertainty is to
shift contractor preferences from a = 1.0 to a < 1.0 when cost
targets are loose; that is, when b < 1.0. It can also be seen that
the greater the standard deviation a of random cost outcome
variations is, the more a is likely to be reduced in response to a
profit ceiling. E(X) will generally be lower under renegotiation
than it would be with no profit constraint, but it is apt to be higher
when technological uncertainty accompanies renegotiation than in
the case of renegotiation without technological uncertainty.
A third distinguishable case occurs when the user cost function
7. The basic structure of an analytical solution can now be suggested.
In place of equation (14), the contractor confronted with a contract^ profit
--'-— 8. an already negotiated a snd Ilr, and a probability distribution
' ' ' 9 m>m their expected value might
f[i\EXX). 0*] of cost outcome deviations
maximize:

E(ULM) = Ui + JalE(X) +n /(«) d[EiX)+8^ - bElX) -

00
with respect to E(X). The derivative would be equated to sero and solved
for E(X),,t. and the result would be substituted into the analogue of (18):
S-k-ha-ma*

- bElXU, - c[B(X).,ilV J , ^
This would be differentiated with respect to a, equated to sero, and solved
for a. But the solution lies far above my poor power to add or subtract.
 THE THEORY OF CONTRACTUAL INCENTIVES 271

is still declining for low positive values of E{X); that is, when
b < 0. Then a value of a less than 1.0 may be optimal even in
tlie case of complete certainty with respect to actual cost outcomes.
In this case the contractor would normally maximize its expected
long-run profit by underrunning to that value of X = X* at which
tiie user cost function attains its minimum, choosing the a which
makes Uo equal to the limit of £1 at X = X*. It is readily apparent
that the greater X* is, the smaller the optimal a will be.
Finally, when b < 0 and actual cost outcomes are subject to
uncertainty, the contractor is likely to seek a higher a and a greater
E{X) than in the third case, since by undermning beyond the
point where the user cost function attains its minimum, the con-
tractor can reduce significantiy the probability that actual contract
profits will tum out to be less than the ceiling.

III. OTTTLAY MINIMIZATION BY THE GOVSBNMENT AS BXTYEB

Let us tum now to the govemment's a choice problem. We
shall assume that tJie govemment seeks to minimize its expected
total contract outlays; that is, cost plus profit. This is not a very
realistic assumption, given the govemment's position as a monop-
sonistic, presumably far-sighted buyer which, among other thinp,
recoups more than half of its contractors' profits through corporate
and individual income taxes.' It is undoubtedly more applicable
to routine commercial contracting situations, but the analysis is
of sufiicient interest to warrant a brief presentation.
The govemment's expected contract outlays E{G) are defined
by the following expression:
(24) E{G) = Cr + Hp - E{X) + aE{X).
Substituting in (5) and (16) for IIT and E{X), we assume that
the government seeks to minimize:
(25) E{G) =CT + k + ha-{-m

Differentiating, we obtain as a first order condition:

dE{G) , 1 6 /I
~~d^ ~~2c~'2c'^ ''\'^~2c
Solving for a, we obtain:
- b - 2cA
(27) ag =
2 + 4cm
8. For a more complete discussion of tbe govemment's objective func-
tion problem, see Scberer, op. eit., Cbap. 8.
272 QUARTERLY JOURNAL OF ECONOMICS

The second derivative is:

For a local minimum, (28) must be positive. If m is negative,

this can occur only when:
(29) TO > - -^.
2c
Are there ever any dtuations involving quadratic user cost and
UT functions in which the optimal choices of a for an expected
profit-maximizing contractor unconstrained by renegotiation or other
profit limitations and an expected outiay-minimizing govemment
buying agency coincide? For the preferences of both parties to be
in harmony under the assumptions made here, the conditions for an
optimal a for the government and its contractor must be satisfied
simultaneously. Solving (19) for a, we find that at the contractor's
optimiiin I

,30) . = ^ I l M . .
1-f 4em
Equating (30) with (27) and solving for b, we obtain:
(31) b = l+2c(2fn-|-A).
When b exceeds this value, the contractar will prefer an a lower
than the govemment's optimal a. The revene is tme when b < 1
-|-2c(2m + A).
It can also be shown, although the proof will not be ^ven, that
the contractor and govemment optimal a are equal only when an
expected cost overmn and firm fixed price contractual caverage
are optimal for both parties. Thus, the a preferences of an un-
constrained expected profit-maximixing contradior and an expected
outlay-minimizing buyer are in harmony only when certain very
special relationships prevail among the parameters of the user
cost and lip functions.'
Therelationshipbetween govemment and contractor preferences
is illustrated in Figure II, which shows the optimal choices of a
for the contractor (solid line) and the govemment (broken line)
for various values of b, assuming that c = .08 and that Ilr = 6
-|- 10a — 4a'. The functions intersect at b = 1.32, where the mutual
optimal a is 1.0.^ When b > 1.32, the govemment prefers FFP
9. To avoid comer solutiono, it is also necessaiy that c and m assume
values which satis^ second order conditions (21) and (29). For a mutual
optimuin, the combination of these two conditions ia very restrictive.
1. Note that these are not reaction functiona—me contnuitor and the
 THE THEORY OF CONTRACTUAL INCENTIVES 273

coverage with a = 1.0, while the contractor prefera a lower value

of a. The more b exceeda 1.32, the lower ia the contractor'a optimal
a. When b < 1.32, the contractor prefera firm fixed price coverage
while the government prefers a lower value of a. The more b
falla ahort of 1.32, the lower ia the govemment'a optimal a.

IV. CONBIBTENCr WITH ElfPIEICAL EvmENCE

How well does the theory preaented thua far, and eapedally
the theory of optimal aharing proportion choice for contraotora,
explain actually obaerved behavior? Two kinda of evidence have
been collected. Firat, data were obtained on the cost outcomea and
aharing proportion arrangementa of 306 Air Force and Navy fixed
price incentive contracta covering the production of weapon ajratems
and aubqyatema with a dollar value of $12.6 billion. Second, in
connection with detailed hiatorical caae atudiea of twelve weapon
ayatem development and production programa, contractor and gov-
emment repreaentativea were interviewed at aome length about
bargaining goala and tactica in the negotiation of numerous specific
contracta.
According to the theoiy developed here, a ao-called incentive
contract, with 0 < a < 1.0, ahould be optimal for the contractor
when a coat underrun ia expected [E(X) > 0] primarily when the
coat target ia negotiated ao looaely that the contractor can expect
to loae through renegotiation aome of the profita which might be
government cannot amply move to the joint optimum. Rather, b is essentially
fixed once cost targets nave been negotiated. The vertical distsnce between
the two optima for any given b represents the area of confiict. Note idso
that if second order constraints (21) and (29) are not satisfied, the HinflmuJ
lines become vertical discontinuities.
274 QUARTERLY JOURNAL OF ECONOMICS

gained by attempting to undermn all the way to the unconstrained

fixed price optimum. If situations of this sort were common, ve
should expect the distribution of profit outcomes from a sample
of contracts to show a special mode in tho 12 to 15 per cent range,
since profits above this range arc seldom retainable on major
defense contracts and contractors would have an incentive to limit
high expected profits to this level through appropriate choices of a
and E(X). In fact, the only available evidence on tliis point —
from a sample of forty-seven Navy fixed price incentive contracts
— displays such a second mode, although the departure from uni-
modality was statistically significant only at the 20 per cent level
and there were other reasons for considering the test inconclusive.^
Now if there were no constraints un defense contract profits
and if contractors' profit expectations were maximized, we should
expect the population of all incentive contracts to contain relatively
few contracts ending in a cost undermn — notably, those resulting
from medium to large positive values of 8 when an overmn was
expected. But in fact, there was a pronounced and statistically
dgnificant undernin bias in the sample of 306 Air Force and Navy
incentive contracts. Some 65 per cent of the contracts ended in
undermns, with a simple average underrun of 2.5 percentage points.
If contractors had maximized their profit expectations subject to
no profit ceilings in negotiating these contracts, the majority of the
contracts should have been written with firm fixed price instead of
the observed fixed price incentive provisions. Or if, because of
extreme Knightian uncertainty, the contractors could not discern
in advance which contracts would underrun but anticipated the
observed underrun bias, they would have maximized the expected
value of their profits by opting for FFP coverage in every instance.
This apparent tendency toward the use of contracts which did
not maximize contractors' unconstrained profits could have several
explanations. It might have resulted from successful govemment
efforts to minimize its expected contract outlays E(G) in the face
of loosely negotiated cost targets. But case study interviews indi-
cated that it was contractors, not the govemment, who typically
fought for low values of a in contract negotiations — the obverse
of what one would predict with an average undermn bias when
contractors maximized unconstrained profits and the government
minimized outlays. And due to their clearly superior knowledge
of underlying cost factors, contractors generally knew much better

2. The data and the test are described in Scherer, op. dt.. Chap. 8.
 THB THBORY OF CONTRACTUAL INCENTIVES 276

than govemment negotiators when cost targets were set so loosely

that an undermn was likdy.
An altemative possibility is that contractors, when confronted
with profit ceilings and uncertainty of cost outcomes, engaged in a
constrained profit maximization process of the type outlined in the
last part of Section II. It seems likely that the existence of rene-
gotiation and other profit recoupment mechanisms did cause some
reduction in contractors' optimal a's. Yet for three reasons this
appears to be only a partial explanation. First, relatively few of
the 306 incentive contracts were negotiated so loosely that large
profit refunds might have been anticipated. Or at least, tiie cost
targets were sddom so loose as to warrant a reduction of a from
the 1.0 value optimal in an unconstrained undermn situation to the
average value of .2 actually observed. Second, because of an over-
simplification, the theoretical analysis of Section II tended to over-
state the impact of renegotiation of a choices. Actually, higher
profits can be retained under contracts with high values of a than
under those with low values of a, and so the incentive generated by
renegotiation to avoid high values of a is not so strong as Section II
implied with its assumption of a constant profit cdling for all a.
Third and perhaps most important, case study interviews yielded the
rather surprising finding tiiat during the period when tiie 306 in-
centive contracts were executed, the existence of renegotiation had
littie impact on contractors' operating and contractual decidons
and actions.'
Much more frequently, contractor representatives mentioned
risk aversion as the principal reason for their efforts to negotiate low
values of a. They stated explicitly that in many instances, given
the uncertainties which pervaded advanced weapon system and sub-
system production programs, they were willing and eager to sacri-
fice the hi^er average profit expectations associated with firm fixed
price contractual coverage for tiie greater security against an occa-
sional short-run loss afforded by CPFF and incentive contracts.
Confidential data from company files on cost expectations and bar-
gaining tactics in specific negotiations tended to confirm these as-
sertions.*

3. For a further explanation, see Scherer, op. dt.. Chap. 8.

4. One might aigue that the acceptance of contracts with a lower
expected profit value but jgreater protection soainst loss is really a form of
long-run profit maximisation, since occasional heavy losses might lead to
bankruptcy or inability to oploit strategic investment opportunities. But
most of the &ms tMoperating m the case study interviews were laige enoujdi
and had sufficient liquidity to absoib such losses with relative impunity, r^e
main basis of the observed ride avendon behavior appeared to be an assump-
276 QUARTERLY JOURNAL OF ECONOMICS

In sum, the available evidence points toward a conclusion that

even when adjustments are made for the existence of profit ceilings,
defense contractors do not behave as the theoiy of expected profit
maximization would have them behave. Instead, they appear to
sacrifice maximum profits in many instances in order to avoid the
risk of loss."

V. TawABD A THEQBT OF R I S K

This candusian indicates the desirability of developing a more

general theoiy of contracting which includes risk averdon as a
contractor goal. Only the barest outline can be suggested here.
The contractor is assumed to maximize a managerial utility function
(32) Y = Y[E{niM),ML),D[E{X)]],
where E{Ilut) is the expected value of long-mn profits as defined
in equation (14), «(L) is the probability of an outright loss on a
contract, and D[E{X)] is the disagreeableness of cost reduction
actions. All are functions of the variables E(X) and a and (with
the exception of D[E{X)]) of the prior subjective probability
dendty function f[S\E(,X), o^] describing the possible deviations
of X from its expected value at any levd of efficiency. Presumably,
Y is an increadng function of EIULK) and a decreadng function
of « (L) and D[E{X)]. To keep the modd manageably simple,
the role of D[E(X)] will be ignored.
The relationship between EiULa) and «(L) can be illustrated
by means of indifference curves Yi, Y2, . . ., Y,, as in Figure III.
The greater the probability of loss, the higher the long-mn profit
expectation required to maintain contractor management at a
constant levd of utility. ZZ' is a profit posdbility function which
relates the amount of profit a contractor can expect in a given con-
tractual relationship to the risk of loss accepted by the contractor.
As a first approximation, it is assumed to be uniquely defined by
E{X) (which in tum depends upon CT and a), U[E{X)], UT
(which depends upon a), and f[S\E{X), a']. The contractor will
maximize its utility by choosing that combination of E{,Ujjt) and
«(L) on ZZ' which intercepts the highest indifference curve. In
Figure III this is at the point of tangency T on Y'.
tion that short-run losses were a symptom of managerial failure and therefore
would be followed by possibly drastic organisational dianges.
5. For dmilar condudons, see John Perry Miller, Pndng of MutUay
Procurements (New Haven: Yale Univerdty ftess, 1949), pp. 130 and 217_;
and Frederick T. Moore, MOtaiy Proeurement andContraetmf: AnBeononue
AnalyA, RM-294S-PR (Santa Monica: The RAND Corporation, 1962), p. 58.
 THE THEORY OF CONTRACTUAL INCENTIVES 277

Figurein
• CU)
Detennining a priori the ahape of the profit possibility func-
tion ZZ' poses difficult problems. It certainly is not related in any
aimple way to a alone. The intercqpt at Z, where $(L) = 0, pre-
aumably coneaponda to a CPFF contract which carriea no riak of
loaa. Thia need not be the leaat profitable position in terms of
expected value, and in fact there may be many aituationa (when
a large overrun ia optimal under the asaumptiona of Section II)
in which a CPFF contract ia the moat profitable. On the other
extreme, the poaition with the higheat risk of loss need not be that
of a firm fixed price contract. Rather, the totality of aeveral com-
plex relationahipa determines the ahape of ZZ'. In general, aa a
ia reduced from 1.0 toward 0:
(a) The potential variability of actual contract profit IIQ from
its expected mean Eillo) due to uncertainty decreaaea. Therefore,
unless £ (no) is negative, 9(L) decreases, probably with diminishing
retums aa a -> 0. The larger the cost outcome variance term or' is,
the more pronounced this tendency will be.
(b) In accord with equation (6), Ilr decreases and ao, ceteris
paribus, EiHut) decreaaes. In addition, becauae the reduction in
Ilr reducea the profit cushion against unfavorable cost outcomea,
4(L) increases.
(c) The government may alao demand (aa it aometimea doea)
a lower coat target C f If thia occura, E(JIut) ia reduced and 9(L)
ia increaaed, ceteris paribus.'
6. A change in Cr also requires a riiift in the indifference map, since the
point at which EIX) = 0—the calibration point for the I/[£(Z)] function
which is a component of EIULM) —shifts.
278 QUARTERLY JOURNAL OF ECONOMICS

(d) The optimal E{X) as defined by equation (16) decreases

unless E{no) is constrained at its ceiling by renegotiation, and so
EiUui) decreases and 9{L) increases, ceteris paribus.
Relationships (a) and the first part of (b) imply a positively
sloped and perhaps convex profit possibility function. Relationships
(c) and (d) and the second part of (b) could act in the direction
of a negative slope. The actual shape depends upon the strength
of the various relationships. It is clear in any event that unless
ZZ' has a positive slope greater than the slope of the relevant Y
curve, a comer solution will prevail, and contractors will attempt
to negotiate CPFF contracts with the minimum risk of loss.
Yet the problem of defining ZZ' is even more complicated. In
a closer approximation to the real world of contracting one must
admit that ZZ' is probably not independent of the utility surface
Yi, . . ., Y,,. Elsewhere I have called the assumption that given a,
b, and c the choice of an optimal E(X) is based only upon the
marginal relationships subsumed in equations (15) and (16) "the
reward theory of incentives."^ But in addition, the analysis in
this and the preceding section shows the need for a "pressure theory
of incentives." If contractors avert risks, their risk avenion propen-
sities undoubtedly affect not only the choice of a, but also the
actual effort to achieve E(,X) once a is negotiated. Observation
reveals that the greater the perceived risk of loss in a contracting
situation, the more vigorously contractors strive to reduce costs
for the sake of avoiding loss as well as for the sake of gaining
increments of profit (or decrements of loss). In this case the ZZ'
function is dependent upon the contractor's utility function and
the partial analysis of Figure III fails. A more general aystem of
independent relationships is required, altiiough this task cannot
be attempted in the present article.

YI. SOME BBOADIEB IIIPUCATIONB

The conclusions that defense contractors' profit maximization

behavior is affected by renegotiation and that contractors fre-
quentiy do not even seek to maximize the expected value of their
profits have, among oUier things, important policy implications.
Recently the Department of Defense has initiated a program to
increase dramatically the use of so-called incentive contracts and
to reduce the use of CPFF contracts. But unless the government is
able to maintain a slope for the profit possibility function ZZ' at
7. Scherer, op. dt^ Chap. 8.
 THE THEORY OF CONTRACTUAL INCENTIVES 279

least initially steeper than contraotorB' Y curves, coniracton are

likely to avoid high-risk contracts. Observation of recent behavior
Buggesta that whenever possible they will hold out in negotiations
for nther low values of the sharing proportion a or high values
of the cost target Cr. The existence of renegotiation and other
more informal profit constraints will also tend to discourage the
acceptance of high values of a.
From the standpoint of botb public policy and positive eco-
nomics, the contractual incentives problem seems a most fertile
area for further empirical research. Our understanding of the
effectiveness of various contract types would increase significantly
from a successful effort to estimate an average value for the e
parameter in the user cost function. And the opportunity exists for
econometric research of considerable practical and theoretical value
on contractor risk aversion propensities. Great quantities of data
on coBt predictions, a preferences, bargaining maneuvers, and actual
cost outcomes are lying fallow in govemment contract files, awaiting
some painstaking (and appropriately cleared) researcher with the
necessary analytical tools.
Research on risk aversion in defense contracting may also add
to our understanding of the behavior of firms in more normal areas
of economic endeavor. To be sure,firmsproducing beans, aluminum
ingots, or typewriters seldom have the opportunity to avoid risks
by operating under CPFF or weak incentive contracts. And it may
well be that the existence of this special opportunity in defense
contracting attracts entrepreneurs and executives who are unusually
strong risk-averters. But my personal suspicion is that the defense
industry is not unique in its risk aversion propensities, and that
similar types of behavior can be observed in, say, the investment
decisions of firms operating in commercial markets.
There is another reason why the defense industry should not
be dismissed as a special case due to its ability to choose among
many values of a. Indeed, it is conventional industry which is the
special case, operating as it almost always does under firm fixed
price contracts, with a = 1.0.' This practice is so deeply rooted in
our commercial traditions that we forget it is a special case, im-
plying a special cost reduction and efficiency equilibrium. If the
analysis in this article is anywhere near correct, a different efficiency
8. Wben tbe existence of corporate profits taxes is taken into account,
tbis is no longer strictly true. A profits tax is spmewbat like an incentive
contract arrangement, cmd tbe analysis in tbis article can easily be extended
to analyse tbe effects of income taxes on effideni^. It sbould be noted tbat
the efficiency effects of an income tax constant over time generally csnod out
280 QUARTERLY JOURNAL OF ECONOMICS

equilibrium would prevail if the traditional value of a were different.

When costreductiongives rise to user costs and disutilities,firmsdo
not move automatically to some uniqudy defined production effi-
ciency frontier. The locus of the frontier depends upon the institu-
tionally given value of a.
if user cost8 are <iie only barrier to cost reduction, since the tax rato appears
as a multiplier before P(t) in equation (12) as well as before a in equation (4)
This is not tme when disutilities block cost reduction.