Optimal contracting with private military and security companies

Abstract Private military and security companies (PMSCs) have been gaining increasing media and scholarly attention particularly due to their indispensable role in the wars in Afghanistan 2001 and Iraq 2003. Nevertheless, theoretical insights into the agency problems inherent when hiring {PMSCs} and how to optimally incentivize them are scarce. We study the complex relationship between intervening state, host state, and PMSC, taking into account the diverging interests of all involved parties as well as potential agency problems. We develop a theoretical model to characterize a state's optimal choice whether to perform a task associated with an intervening mission itself, or hire a {PMSC} and optimally design the contract. We find that it might be optimal to hire {PMSCs} even if they are expected to do a worse job than the intervening state would do itself. Furthermore, the government's reputation in rewarding {PMSCs} for a good performance is crucial and might render it optimal to only deal with a limited number of {PMSCs} — who are not necessarily always the most efficient providers.