Adaptive Contracting: The Trial-and-error Approach to Outsourcing

Adaptive contracting occurs when a principal experiments with the delegation of authority through leaving contracts incomplete. We highlight two potential benefits of adaptive contracting: First, the delegation of authority can be advantageous even if the agent acts opportunistically, since expected private benefits will be shared between the parties through price negotiation. Second, the principal extracts information from experimenting with delegation of authority and we identify a positive option value embodied in the principal’s ability to extend or withdraw the delegated authority in future contracting periods.