Decentralization of contracts with interim side-contracting

This article gives a new explanation for the phenomenon of subcontracting. A model in which a principal contracts two agents who work in a sequence on a project, have soft information and can collude is considered. Side-contracts between agents can be signed at any stage of the game. It is shown that in this setting both a decentralized contracting structure, in which contracting of the agents at the initial production stage is delegated to the agent at the final production stage, and a centralized structure, in which the principal directly contracts both agents, can be superior for the principal. The article derives the conditions under which this holds. The results give an explanation for recently observed tendencies in public procurement of design and construction activities. Copyright Springer Science+Business Media, LLC. 2012