Contracting with multiple agents, countervailing incentives, and industrial structure

This paper examines optimal industrial structure in a setting in which a government contracts with two firms having private information and is subject to type dependent participation constraints. The literature on incentives under asymmetric information has been concerned with countervailing incentives only for the cases of a single agent. We extend this literature to the case of multiple agents and demonstrate that countervailing incentives can arise in that setting. We analyze a contracting model in which the government (a principal) procures two complementary products or facilities from the two firms (agents) with private information on production costs. We consider two different forms of industrial organization. One industrial structure is a decentralized industry in which each of the two firms supplies its own product to the government. The other industrial structure is an integrated industry in which the two firms are integrated and supply both products to the government. Unlike the existing literature on optimal organizations with multiple agents under asymmetric information, we examine the setting in which each firm's cost is comprised of not only a constant marginal cost but also a fixed cost, both of which are its private information. We characterize optimal industrial structure based on the differences in the firms’ fixed costs. We show that when a difference in the size of fixed costs with respect to each firm's types is null or sufficiently small, the government's payoff under the integrated industry is greater than that under the decentralized industry. We also show that there are cases in which the optimal industrial structure is the decentralized industry when the difference in fixed costs with respect to the firms’ productivity types is not small.