Repeated Auctions of Incentive Contracts, Investment and Bidding Parity with an Application to Takeovers

This paper considers a two-period model of natural monopoly and second sourcing. The incumbent supplier invests in the first period. After observing the incumbent's first-period performance, the buyer may breakout in the second. The investment may be transferable to the second source or not; and may be monetary or in human capital. The paper determines whether the incumbent should be favored at the reprocurement stage, and how the slope of his incentive scheme should evolve over time. It results from our analysis that the gains from second sourcing are not as high as one might hope. Last it reinterprets the second source as a raider, and the breakout as a takeover. It discusses the desirability of defensive tactics, and obtains a rich set of testable implications concerning the size of managerial stock options, the amount of defensive tactics, the firm's performance and the probability of a takeover.