Designing price contracts for procurement and marketing of industrial equipment

A durable goods contract typically specifies a price determination process, which is an integral part of "rules of the game" that govern the exchange between the contracting parties. Drawing on principles of new institutional economics, these contractual price processes are arrayed on a flexibility continuum ranging from predetermination through redetermination to renegotiation. A well-designed contract specifies a price process that is aligned in a discriminating fashion with the two fundamental problems of efficient exchange-adapting to changed circumstances, while simultaneously safeguarding against opportunism. A simple but effective price design rule is as follows: Greater adaptation needs call for moving away from predetermination processes toward renegotiation processes, while increased opportunism hazards call for moving in the opposite direction. The proper balance is illustrated with two cases involving durable goods. The choice between cost-plus price contracts versus fixed price contracts is shown to yield to this design principle as does the choice between outright sales contracts versus operating leases contracts.