Sticks and Carrots in Procurement: an experimental exploration

We test the robustness of recent findings on the benefits of penalty contracts to the environments typical of B2B (and B2G) procurement, where buyers and sellers interact repeatedly, matching is endogenous and competitive, there are contractible and non-contractible tasks, and reputation-based relationships can emerge. Both bonuses and penalties boost efficiency, strongly increasing effort in the contractible task while only mildly crowding it out in the non-contractible one. However, sellers grab a higher fraction of surplus with bonuses, as buyers’ offers become more generous. Consequently, buyers prefer penalties, which may explain why they are so widespread in procurement.