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Keywords:

  • Flexible Price Contract;
  • Gain-Sharing Contract;
  • Geometric Brownian Motion;
  • Mean-Reverting Process;
  • Outsourcing;
  • Winner's Curse

ABSTRACT

This research utilizes real options theory to investigate how to break the winner's curse in contracting through effective contracting mechanisms. We focus on two contracting approaches: flexible price contract and gain-sharing contract. For reasons of analytical tractability, we first utilize the geometric Brownian motion as the dynamic model to obtain closed-form solutions to break the outsourcing winner's curse. Subsequently, we extend our model to the mean-reverting process and provide numerical examples to verify the validity of our closed-form results, which have not previously been presented in the outsourcing literature. Finally, we provide prescriptions for the problem of the winner's curse in outsourcing.