Incentive Contracting for National Defense: A Problem of Optimal Risk Sharing

This paper analyzes risk sharing in defense contracting within an insurance framework with moral hazard present. The positive model specifies conditions under which risk sharing between the firm and the government can be expected to occur, and identifies the important exogenous characteristics of the firm that determine the equilibrium set of contract terms. An important public policy implication is derived from a normative comparison between the simple incentive structure currently used in defense contracting and a modified contingent claims arrangement. The latter is shown to be superior in providing desirable risk sharing, while also maintaining appropriate marginal incentives for cost control.