Optimal Design and Selection of Software Outsourcing Contracts in the Presence of Bilateral Moral Hazard

ABSTRACT In the realm of software outsourcing, client participation throughout the software development lifecycle is of paramount importance in determining the success rate of projects. Effective collaboration between clients and software developers is crucial for improving project quality. However, the privacy surrounding their efforts often leads to bilateral moral hazard challenges. To address these complex issues, this study employs the Nash bargaining game theory to construct a theoretical analysis framework for the design and selection of performance‐based contracts and time‐and‐materials contracts. The research finds that comparing the cost‐efficiency parameters and effort elasticity coefficients of both clients and developers can reveal the relative magnitude of their respective effort levels. Furthermore, the reward coefficients in both types of contracts are closely related to the software developer's cost of fixing bugs, the client's sensitivity to bugs, and debugging time. Additionally, the reward coefficient in time‐and‐materials contracts is also influenced by the software developer's effort costs. Through comparative static analysis, the study further discovers that if clients are generally sensitive to software bugs, performance‐based contracts exhibit better incentive effects than time‐and‐materials contracts; if clients are highly sensitive to software bugs, time‐and‐materials contracts are preferable to performance‐based contracts.