Simple probability models for project contracting

There are two aspects to the process of price setting using sealed bids. The project owner is interested in deploying the contract mechanism that will secure reliable service at the cheapest cost. On the other hand, each contractor bidding for the project is interested in winning the contract but at a price that assures him a reasonable profit margin. We use a parsimonious stochastic model to compare and contrast some commonly used contracts from the point of view of the project owner. We show that if the bidders are risk neutral, a Fixed Price contract results in the smallest expected procurement cost for the project owner. We introduce and analyze Menu contracts and show that the expected price of a Menu contract lies in between the prices of the Fixed Price and Cost Plus contracts for the same project. We analyze how risk aversion and collusion, which we model using concepts of stochastic dependence, impacts the average winning bid price.