Executive Summary:
The growth in the information technology (IT) services
market and the increasing tendency of firms to outsource some or all of their
IT functions necessitate better mechanisms for selecting IT vendors. For most
projects, there are a multitude of potential vendors that differ in quality and
other aspects that are difficult to assess at the time of contracting. In
addition, many projects have outcomes that are difficult to measure or verify
by outside parties – as a result, mechanisms that require observability
of outcome, such as incentive contracting, only provide limited benefits in
vendor selection and in some cases are ineffective or counterproductive.This
paper presents an alternative mechanism for selecting high quality vendors
using a two-stage contract. In the first stage, the client engages a vendor
for a pilot project and observes the outcome. Using this observation, the
client makes a decision whether to continue the project to the second stage on
pre-specified terms or to terminate the project. By setting compensation for
the pilot sufficiently low, and establishing a threshold performance level for
continuation, the client can offer a contract that is only attractive to high
quality vendors.Using game theoretic analysis we find that this contract
performs better for the client than random selection among seemingly equally
qualified vendors. This mechanism is useful in settings where vendor quality is
uncertain, and especially in situations where a pilot project is undertaken for
other reasons (such as demonstrating technical feasibility), where the benefits
of this contracting mechanism can be realized at little incremental cost. |
