This paper was was written by Trevor Brown (John Glenn School of Public Affairs, The Ohio State University), Matthew Potoski (Department of Political Science, Iowa State University), and David Van Slyke (Maxwell School of Citizenship and Public Affairs, Syracuse University) for the Kettering Symposium on Public Accountability, May 22 - 24, 2008. It is an interestingly insightful and useful paper that has be used as a reference point for the February 4th, 2010 Contacting Intelligence Post: Complex contracting in the public sector: Managing relations and negotiating contracts in the absence of market discipline (http://wp.me/pYOvn-7u)

1. Accountability Challenges in Public Sector Contracting for Complex
Products
Trevor Brown
John Glenn School of Public Affairs
The Ohio State University
1810 College Road
Columbus, OH 43210-1336
E-mail: brown.2296@osu.edu
Matthew Potoski
Department of Political Science
Iowa State University
519 Ross Hall
Ames, IA 50011
E-mail: potoski@iastate.edu
David Van Slyke
Maxwell School of Citizenship and Public Affairs
Syracuse University
320 Eggers Hall
Syracuse, NY 13244
E-mail: vanslyke@maxwell.syr.edu
Manuscript prepared for the Kettering Symposium on Public Accountability, Dayton, OH,
May 22-24, 2008

2. Accountability Challenges in Public Sector Contracting for Complex Products1
Governments buy lots of goods and services. The U.S. federal government spent over
$419 billion in fiscal year 2006 for procurement, almost double 2001 procurement expenditures
(Hutton, 2008). The rationale for buying is to lower costs through scale or market efficiencies,
spark service delivery improvements or innovation through competition, and access expertise or
capacity unavailable in-house (Kelman, 2002). The risks are that contracting’s cost savings are
sometimes illusory, quality suffers, and delivery delayed (Sclar, 2000).2 Some fear that such
large scale procurement undermines accountability: when government purchases rather than
produces, the chain of accountability is extended yet further and perhaps even weakened. People
working for government are more easily held accountable than people working for organizations
that sell to the government. When contracting fails, contracting muddles responsibility: does
fault lie with the seller, the buyer, or unforeseen circumstances that nature delivered?
Contracting produces low risk win-win outcomes when markets function well: markets
need enough buyers and sellers, buyers and sellers need to be well informed about products and
each others’ preferences, and actors must be able to easily enter and exit the market and
exchange resources at low costs.3 Market discipline provides its own accountability by revealing
who is responsible for deals gone bad and then punishing them for their transgressions. Buying
1
This research is partially funded by the IBM Business of Government Foundation.
2
There are other risks associated with contracted service delivery, like nepotism or cronyism. Depending on the
circumstances, these risks are also present for internal service delivery. Because so much is made of service quality,
cost and timeliness in the comparison between internal versus contracted service delivery, we focus our discussion
on these three.
3
There are several ways to view the sources of market failures, including incomplete property rights, transaction
costs, and information asymmetries. Goods may be non-rivalrous or non-excludable so that transferable property
rights cannot be established and enforced without transaction costs swamping gains from trade (Weimer and Vining,
1999). Historical accident may inefficiently lock in path dependent technologies such as the QWERTY keyboard
(David, 1985). Information asymmetries between buyers and sellers may create a “lemon market” where inferior
products keep good products off the market (Akerloff, 1970). A common thread in these cases is that the market
failure is caused by the transaction costs stemming from limited information among participants, particularly buyers,
or from goal incongruence between the buyers and sellers.
1

3. and selling is more complex when the market is thin (few buyers and sellers), buyers and sellers
are uncertain about the terms of exchange, and the future is unpredictable. Complex
circumstances threaten the win-win gains from market exchanges and obfuscate responsibility
for failed exchanges.
Contracting in complex circumstances does not guarantee failure, but it does make it
more likely. Buyers and sellers can no longer rely on market discipline, but instead must manage
their relations to ensure the exchange bears its win-win fruits. In this paper we investigate
accountability issues raised when governments purchase complex products. Our inquiry uses the
simple but powerful heuristic of game theory to show the complexities of accountability
questions in public sector contracting. The outcome of a complex contract exchange is the result
of the buyer’s and seller’s efforts – whether they have made good faith efforts to maximize the
mutual gain the contract can generate – as well as the luck of nature – unforeseen forces make
some apparently difficult tasks turn out to be easier and some easy ones harder. Because the
effects of these factors are generally unknown, it is difficult to determine whether the outcome of
a complex contract was due to a well managed process or fortunate circumstances. Our
theoretical inquiry highlights how buyers and sellers can improve the chances of win-win
outcomes and make the contracting process more accessible and accountable.
This paper is divided into four sections beyond this introduction. In the first section we
distinguish between simple and complex products, and then highlight the risks and rewards of
contracting for complex products. In the second section, we describe the basic bilateral
contracting game. We then use the contracting game to identify accountability challenges in
contracting for complex products. Fundamentally we show the challenges of trying to determine
whether outcomes result from the behavior of the two parties to the exchange or exogenous
2

4. factors. In the third section we provide an illustration of these accountability challenges – the
Coast Guard’s Project Deepwater, a multi-year, multi-billion dollar procurement. In the fourth
and concluding section, we summarize our arguments by highlighting important implications for
contracting practice and accountability.
Simple and Complex Contracting
Successful contracting delivers a win-win exchange between buyer (in our case a
government agency) and seller (a private firm, a nonprofit organization, or even another
government). Buyers seek goods or services that meet their expectations for quality at a price
lower than the value they attribute to the product, while sellers want compensation that exceeds
their costs for producing the good or service. Much of what government buys are what we call
simple products. For simple products, buyers and sellers can easily define cost, quality and
quantity parameters, and there is a vibrant market of buyers and sellers with many exchanges and
clear price, quantity and quality signals. In a market exchange for simple products, the buyer can
describe with a high degree of detail what it wants the seller to do or produce. While a contract
can be specified in a variety of forms – such as inputs and tasks, the outputs, the outcomes, or
some combination of these (Bajari and Tadelis 2001; Heinrich 1999; Martin 2004; O’Looney,
1998)4 – overall, contracts for simple products are relatively complete in the sense that they
unambiguously define each party’s obligations. If for some reason a buyer or seller fails to live
up to her contractual obligations, the transgression is quickly and easily recognized and a richly
competitive market provides a replacement partner seeking similar terms. When contracting for
4
Contract completeness is the degree to which these elements are contractually specified, most importantly by
defining task, outcomes, and compensation as the basic terms of exchange. These core elements structure the
degree to which the contract is complete. Around these core elements, contracts can also be more or less complete
based on the nature of the governance features that specify how the exchange will take place and how the parties
will interact in the course of delivering the service (Brown, Potoski, Van Slyke, 2008).
3

5. simple products, buyers and sellers can be reasonably confident of achieving the mutual gains
from successful win-win market exchanges.
Rosy win-win scenarios are less likely in contracting for complex products where neither
buyers nor sellers know the products’ cost, quality and quantity parameters ahead of negotiation
and production.5 Complex products are exchanged under incomplete contracts because
uncertainty is so high that the costs of writing out all contract terms to account for all future
scenarios exceed the mutual gains from the trade and no contracting would occur. The
consequence of an incomplete contract is that an uncertain future can create ambiguities about
roles and responsibilities and produce circumstances that favor one party at the expense of the
other. Consequently, the costs of contracting include the risks of renegotiations and of being
held to contract obligations that unforeseen circumstances have made unfavorable. These
unforeseen circumstances, what we call nature, can fundamentally change the payoffs for
producing, exchanging and consuming a product, making it more valuable to the buyer, raising
its production costs, and so on.
Parties to complex contracts can work ex ante to reduce uncertainty so the contract can be
more specific, such as investing in research and development, or write a less specific contract
expecting to renegotiate ambiguities ex post as the product is produced and the exchange
executed. Such investments are asset specific to the extent they can not be put to alternative use.
In an exchange with asset specific investments, incomplete contracts coupled with uncertainty
about the future raise the specter of the classic hold-up problem (e.g. Williamson, 1996). From
the buyer’s perspective, the risk of making an asset specific investment is that once the
investment has been made, there is no alternative seller for the product, which means the seller
5
A lot has been written about lemons markets where buyers are uncertain about the product but sellers are not
(Akerloff 1970). In this paper, we focus on contracts where buyers and sellers each are initially both uncertain.
4

6. can exploit contract ambiguities to “hold up” the buyer to extract more favorable terms, even
terms that the buyer would not have agreed to with foreknowledge. This fear is complicated by
the fact that for many complex goods and services, government is the only buyer (e.g. weapons
systems); once the buyer makes a decision about a particular product or solution the market
clears as other potential sellers have no purchasers for their proposed product or solution. The
seller faces a similar dilemma in that they devote significant resources to develop (and perhaps
design) a specific solution for the buyer and face the uncertainty that at some point in the future
the buyer may walk away from the contract for any number of reasons (e.g. the product doesn’t
successfully address the buyer’s needs, authorizers prohibit the buyer from continuing with the
procurement).
Incomplete contracts for complex products are also vulnerable to the vagaries of an
uncertain future: unforeseen circumstances may leave either party trapped in a contract it would
not have entered had it known what was to come. Producing the product reduces uncertainty as
sellers, and perhaps to a lesser extent buyers, learn about the product and its quality-cost
tradeoffs. Such learning can be captured as lower production costs and scale economies if the
contract is for multiple products of the same type. It is important to note that the fruits of
reduced uncertainty are not necessarily enjoyed equally by buyers and sellers. For example,
governments may realize that the delivered service does not meet what is needed or vendors’
production costs may turn out to be much higher than anticipated, with the government enjoying
cost savings and the vendor suffering losses. Incomplete foreknowledge also means that either
side may find itself in a position to exploit unforeseen circumstances for its own advantage. A
seller, for example, may exploit contract ambiguities to lower service quality because the
contract may lack provisions for the buyer to enforce original terms. In the absence of clear and
5

7. specific tasks, outputs, or outcome terms, the seller may misrepresent the quality of its “product”.
On the other hand, the buyer, because it may have delivered the service directly in the past, may
have more information about the challenges the seller is likely to face as it delivers the service.
The buyer can use this first-hand knowledge opportunistically to negotiate a contract that fails to
specify the known conditions under which the seller can claim compensation for costs.
All in all, we can see that achieving win-win outcomes in more difficult in contracting for
complex products. Complex contracting’s success is a function of managing the uncertainty
associated with both the behavior of the other party and the unexpected impacts of exogenous
natural factors. Ex ante, both parties to the exchange can take a variety of steps to promote
positive cooperation, such as signaling cooperation and concern about future contracting,
revealing information about production and profits, and so on. As nature reduces uncertainty,
buyers and sellers can renegotiate contract terms, adjusting the existing contract midstream or
writing new terms for future transactions. This assumes, however, that the buyer and/or the seller
can identify nature’s impact on contracting’s outcomes. Both parties may have the advantage of
more information than when they entered into the initial agreement, but perhaps not sufficient
information to discern the causes of the outcome they and the other party received. The relative
level of information at this ex post phase highlights the accountability challenges of contracting
for complex products. In the next section we turn to game theory as a tool to help analyze the
contracting process as it unfolds from the ex ante to ex post stage.
The Contracting Game
Contracting can be viewed as a bilateral game between a buyer and a seller. For each
party, the risks and rewards, or payoffs, of a contract reflect the contract’s design (i.e. each
6

8. parties’ responsibilities), the behavior of each player relative to the behavior of the other player
(i.e. the players’ “moves”), and exogenous factors (i.e. nature). Payoffs reflect the objectives of
each player; buyers seek to optimize across cost and quality (inclusive of timeliness), while
sellers seek to maximize profits. Treating contracting as a simple bilateral game provides a
powerful heuristic for examining the possibility of a win-win outcome for complex contracting,
as well as for identifying key accountability issues. In this section we present a basic contracting
game with four discrete phases described below.
In the first phase of the contracting game, the buyer and seller negotiate contract terms
and decide whether to make any asset specific investments to produce the good or service (e.g.
research and development). Higher asset specific investments mean higher hold up risks; lower
investments mean a less precise contract and a higher risk of renegotiation costs in the future. In
the contracting game’s second phase, the buyer and seller simultaneously decide and execute the
approach they intend to take in fulfilling their responsibilities – however clearly or unclearly
defined – in implementing the contract. A party that chooses to “cooperate” executes her
contract obligations with the goal of maximizing win-win gains for both sides, even if she could
have done better (and her partner done worse) through another strategy. Alternatively, a party
that chooses to “defect” makes minimal investments in achieving a win-win gain for both sides,
and perhaps pursues a strategy of ensuring a win for herself even if it results in a loss for the
other party. In the third phase, “nature” reveals itself as positive or negative exogenous factors
that affect the product’s costs and qualities. In the fourth phase players’ strategies combine with
nature to determine payoffs (e.g. win, win). At this point, buyer and seller enjoy more
information than at the outset and hence have the opportunity to renegotiate contract terms ,
7

9. leave the contract in place, or exit the contract.6 Figure 1 models the game’s four phases
graphically.7
[INSERT FIGURE 1 HERE]
In a classic prisoner’s dilemma game each player improves his own position by defecting,
no matter what the other player’s strategy, even though mutual defection leaves the two players
worse off than cooperation.8 Assuming a one shot purchase, we can see how contracts for
complex products mirror the basic prisoner’s dilemma game. Each party may find itself
strategically advantaged in the contract to the extent the other side has made asset specific
investments and the extent to which unforeseen circumstances allow it to exploit contract
ambiguities for its own gains and at the other side’s expense. A seller, for example, might find
himself with the opportunity to “gold plate” the product by adding costly features that increase
his profits but add little value and considerable expense for the buyer. Likewise, a buyer may
force a seller to produce an expensive product even with knowledge that a much cheaper product
would meet her needs almost as well. The problem in these cases is that the winners’ gains are
smaller than the losers’ losses. In other words, the winner’s choice gives him a larger share of a
smaller pie. Alternatively, the winner could make decisions to maximize her own gains only
when the gains are larger than the other side’s losses, and may even take on losses for herself if it
means larger gains for her partner.
6
In the event that the contract is finished at this point, but the buyer still demands more of the product, the
alternatives are to draft a more complete contract for new purchases, utilize the same incomplete contract again, or
forgo the exchange.
7
Note that in the second column even though the buyer’s decision to cooperate or defect is presented first, buyer and
seller make their strategy decision simultaneously without knowledge of the strategy decision of the other party.
8
An appendix displays the basic payoff matrix of a simple prisoner’s dilemma game.
8

10. After parties have selected their contract strategy and begun to execute the contract,
nature intervenes to affect the payoffs parties receive. The affect of nature is random in the sense
that the parties did not know the probabilities or events that could occur. Perhaps it turns out that
the product is cheaper to produce than anticipated. Or perhaps the buyer learns that the product
will be even more valuable than she had anticipated. Nature can affect buyers and sellers, but
buyers and sellers do not necessarily know how nature affected them or the other party. For
example, if a seller easily solves a problem thought to have been difficult was it because of luck
or because the problem was easier to solve than anticipated?
Payoffs in the contract are determined by the buyer’s and seller’s combined strategy
choices, and the fortune nature has brought them. The parties’ strategic choices affect payoffs in
the manner proscribed by the prisoners’ dilemma: the combined payoffs are highest if both
pursue cooperative strategies, although each can do better by defecting when the other
cooperates. If both defect, the combined payoffs are lowest. In our version of the complex
contracting game, each player knows their own payoff from the game, but not the other’s, and
neither player knows why the payoffs turned out as they did. The problem is that the other
player’s strategy, payoffs and contribution of nature all occur under the shroud of uncertainty.
Figure 2 depicts the second through fourth phases of the contracting game – strategy
selection, the impact of nature, and payoffs. The figure maps the prisoner’s dilemma strategies
and payoffs with the outcome of nature in a simple tree-form of the game. When the buyer and
seller both cooperate, the payoffs are three for each, and when they both defect, the payoffs are
two. If one cooperates and the other defects, the cooperator receives one and the defector
receives four. Figure 2 depicts the effect of nature as a plus or minus two, which to simplify our
illustration we show affecting equally buyer and seller payoffs. There are more complex and
9

11. realistic ways of depicting nature’s role in this game; nature’s payoff can be more variable, such
as by favoring one party while harming another, and by different amounts. We keep Figure 2
simple to convey the model’s underlying logic.
In the most favorable scenario in Figure 2, both the buyer and seller choose a cooperative
strategy and nature provides favorable conditions, giving each side a payoff of five: three each
from mutual cooperation plus nature’s positive contribution of two to each. Had nature not been
so fortunate, the payoff would have been lower, perhaps three or less for the buyer and seller had
nature’s contribution been zero or a negative value. If the buyer chose to cooperate and the seller
chose to defect, the buyer’s payoff would be lower – in Figure 2 it would be only one exclusive
of nature’s combination. If in this scenario nature’s contribution is positive, the buyer could end
up with a payoff that is higher than she would have received under a mutual cooperation scenario
with a negative nature payoff.
This theoretical depiction of complex contracting raises fundamental issues for
accountability in public sector procurement. The buyer only knows her own contract strategy
and her own payoff; the seller’s strategy and payoff, and nature’s contribution are all unknown to
the buyer. Consequently, the buyer can not discern the extent to which the payoff she receives
results from the interaction between her strategy with the seller’s or from nature’s fortune.
Consider further the case of a buyer who has chosen a cooperative strategy: a moderate payoff
for the buyer may be the result of a cooperative seller strategy coupled with a penalty from
nature, or may be the result of fortunate natural circumstances coupled with the buyer choosing a
defect strategy. Such uncertainty is pervasive to the extent the buyer does not know nature’s
contribution to the payoffs or the buyer’s strategy.
10

12. Illustration: Accountability Challenges in the Coast Guard’s Project Deepwater
In this section we present an example – the Coast Guard’s Project Deepwater – to
illustrate the accountability challenges inherent in contracting for complex contracts. We use the
basic logic from the contracting game described above to highlight the challenges of complex
contracts. Negotiations occurred in a context of high uncertainty and fear of lock-in. The
resulting contract was incomplete. The Coast Guard and the selected vendor both proclaimed
they were choosing cooperative contracting strategies, although these claims are difficult to
verify. The contract’s initial payoffs were lower than anticipated for both the buyer and seller,
although it is difficult to determine whether this was the result of contract strategies or an
environment that turned out to be less favorable than anticipated. We conclude this section by
highlighting the accountability challenges faced by the Coast Guard and its political overseers as
the Deepwater procurement moves forward.9
Project Deepwater Background
In recent history the Coast Guard’s procurement practice was to separate purchases for
individual classes of vehicular assets – ships, cutters, planes and helicopters; when a class of
ships was no longer sea worthy, the Coast Guard bought a new one to replace it, perhaps with a
modified design better suited to the Coast Guard’s evolving mission.10 Because it bought fewer
and smaller assets relative to other major naval buyers – notably the U.S. Navy – the Coast
Guard largely made ad hoc purchases from a handful of small sellers (e.g. regional shipyards
9
This section is based on a series of interviews with participants involved in Project Deepwater along with
testimony, oversight reports, and publicly available material produced by the vendor and the Coast Guard. The
Deepwater Program acquisition is continuing. At this stage we highlight early accountability challenges.
10
The Coast Guard’s mission is that of a law enforcement and military organization and it is engaged in maritime
security (upholding the law), maritime safety (rescuing the distressed), the protection of natural resources
(protecting the environment), maritime mobility (ensuring safe marine transportation), and national defense
(operating in coordination with the U.S. Navy).
11

13. such as Bollinger). Without significant procurement experience or capacity, and purchasing only
infrequently and for small quantities, the Coast Guard sometimes even acquired assets as part of
larger U.S. Navy procurements.
By the early 1990s it became clear that the Coast Guard needed a more targeted and
strategic approach to upgrade its rapidly aging asset fleets.11 Many of the Coast Guard’s assets
were reaching the end of their usable life-span and were not ideally suited to the modern Coast
Guard’s missions. In response, the Coast Guard leadership lobbied for a long-term acquisition
strategy that would upgrade and modernize the entire Coast Guard fleet. The Coast Guard’s goal
was to acquire a system of interoperable assets whose seamless communication and coordination
would make the efficacy of the whole greater than the sum of its parts. In 1998, Congress and
the Clinton administration committed to a multi-year procurement at $500 million a year,
significantly more than the Coast Guard’s historical acquisition expenditure.12 The result was the
Deepwater program or Project Deepwater.
The Coast Guard essentially sought a complex product for its Deepwater upgrade. The
Coast Guard and prospective sellers faced high levels of internal and external uncertainty. In
terms of internal uncertainty, the challenge was to design and build an array of sophisticated
interoperable assets – that is they all had to be able to communicate with each other and
seamlessly coordinate their activity in pursuit of different targets (e.g. armed speedboats running
contraband, sailors lost at sea, make-shift vessels porting illegal aliens) – with a hard cap on
overall costs (i.e. $500 million a year). The seller also had have the production capacity or
purchasing ability to deliver very different kinds of assets: ships, cutters, helicopters and planes.
11
As of 2001, eight-six percent of the Coast Guard’s assets, deepwater and air, had reached or were expected to
reach the end of their planned service life within five years. The Coast Guard’s fleet of assets was widely considered
to be one of the oldest in the world, ranking 37 out of 39 of the fleets worldwide (Acquisition Solutions, 2001, p.6).
12
http://govinfo.library.unt.edu/npr/library/news/062999.html
12

14. In terms of external uncertainty, the distributed global reach of the Coast Guard meant
that the environmental conditions and operational missions varied dramatically from location to
location. Coast Guard ice breakers in the Bering Strait needed ships that could do different
things than Coast Guard personnel responsible for drug interdiction in the waters off Florida. In
addition, while Coast Guard had secured the commitment of one administration and the sitting
Congress to a $500 million-a-year procurement budget, there was no guarantee that subsequent
administrations and Congresses would adhere to that pledge.
The combination of interoperability, dual aerial and naval production capacity, varying
environmental and mission requirements, and tenuous political commitments translated into an
asset specific buy with a significant risk of lock-in. To meet the Coast Guard’s request the seller
would have to make high up-front investments to design and build a product to meet the specific
needs of a single client with the real possibility that the client may be forced to walk away from
the commitment at a later date. The seller would then be left with a product, and perhaps a
production process, for which there were few, if any, other buyers. For the Coast Guard the risk
was that the seller that won the bid would eventually gain an information advantage over the
Coast Guard as it began to design and build the product. At the same time, absent any other
buyers of similar products, the market would clear. If things went wrong with the selected seller
(e.g. the seller began to “gold plate” the product), the Coast Guard would have limited options on
where to go to acquire alternative aerial and naval production capacity and systems engineering
expertise.
13

15. Contract Negotiation
In 1998, the Coast Guard issued an RFP describing the mission needs and performance
goals it sought for its upgraded fleet, including the interoperability of its assets, and inviting
industry to propose creative solutions. The Coast Guard evaluated the three industry proposals it
received based on the degree to which they met mission requirements, lowered total ownership
costs, and, to minimize risk, relied on proven, off-the-shelf technologies. The Coast Guard
selected Integrated Coast Guard Systems’ (ICGS, a consortium between Lockheed Martin and
Northrop Grumman) proposal to upgrade or replace ten new asset classes of air and sea vessels
by 2027.13 Under the ICGS proposal, the modernized Deepwater Coast Guard force would not
only be technologically advanced, but each asset in the system would also be fully integrated in a
state-of-the-art command, control, communications, computers and intelligence, surveillance,
and reconnaissance system commonly referred to as C4ISR.
In June 2002, the Coast Guard awarded to ICGS an initial contract for designing,
building, integrating, and testing the assets in the system. At this early stage, most of the work
was for system and asset design and testing, including specifying performance standards for the
system and each of the planned assets. Under the contract terms, ICGS had full technical
responsibility for designing and constructing all Deepwater assets, and for deciding whether
contract components should be put out for competitive bids in second tier contracts.
Given the uncertainty faced by both the Coast Guard and ICGS in producing a complex
product, or system of products in this case, the two parties entered into an incomplete contract to
govern the exchange – a performance-based indefinite delivery, indefinite quantity (IDIQ)
contract. In the simplest terms, an IDIQ does not specify a firm quantity of products or the tasks
13
ICGS proposal included five new sea vessels, two fixed-wing aircraft, two helicopters, and one unmanned aerial
vehicle. The other assets were upgrades.
14

16. required to produce them. Instead, it must either specify a minimum or a maximum number of
products and some end-point for termination of the agreement.14 The Coast Guard and ICGS
agreed to an initial IDIQ contract for five years, renewable in five year increments for a total of
twenty-five years. Within this contract architecture, ICGS and the Coast Guard agreed to
negotiate individual task orders for specific work to be performed (e.g. designing, building and
testing three National Security Cutters, the largest class of ships in the Coast Guard fleet). The
contract specified broad goals in the form of the general assets categories, the performance
specifications for the assets, and a ceiling on the number of assets within each class. It did not
specify a minimum number of assets (a floor) or the actual design specifications of the assets.
The latter was to be worked out through a variety of governance mechanisms, notably individual
task orders and Integrated Project Teams (IPT) for each of the asset acquisitions. The IPTs were
collaborative governance mechanisms that brought together ICGS personnel, relevant
subcontractors, and Coast Guard officials to negotiate and decide which technologies would be
used to meet overall mission requirements. In short, it created vehicles and venues for
negotiation and renegotiation, but did not specify the rolls, responsibilities and authorities of
various actors in these processes.
Strategy Selection, Nature and Payoffs
With the IDIQ contract architecture, the individually negotiated task orders, and the IPTs
to govern the details of the design and production process, both ICGS and the Coast Guard
claimed that they had cemented a “partnership” rather than entering into an arms length
14
See e.g. FAR Subpart 16.5 – Indefinite-Delivery Contracts
(http://www.arnet.gov/far/current/html/Subpart%2016_5.html#wp1093133)
15

17. transactional relationship. At they outset, they signaled to each other that they would
“cooperate” in game theory terms.
At this point unexpected external forces changed the dynamic of Project Deepwater. The
terrorist attacks of September 11, 2001 spurred the assignment of the Coast Guard to the newly
created Department of Homeland Security (DHS). This added new mission requirements to the
Coast Guard’s already extensive panoply of missions; the Coast Guard was now responsible for
collaborating with other government agencies to help prevent future terrorist attacks on U.S. soil.
Not only did Coast Guard’s assignment to DHS create mission strain, but it also increased Coast
Guard’s “operational tempo”, or the speed at which Coast Guard had to prepare and conduct its
tasks and functions. 15 In response to these external events, Coast Guard acquisition personnel
made significant changes to the overall Deepwater program, both by adding new assets and
changing some of the performance requirements for planned asset acquisitions. For example,
post 9/11 the National Security Cutter class of surface assets had to be able to withstand a
nuclear, biological, and chemical attack, a non-trivial change.
Perhaps operating under the assumption that in their “partnership” with ICGS these
changes could be made easily, Coast Guard elected not to engage ICGS in their discussions
about modifying the Deepwater program. This was most apparent in the IPT meetings where
ICGS personnel chaired and ran the coordinating and planning decision making process, and
Coast Guard personnel in attendance did not actively participate.16 Ultimately, Coast Guard
acquisition personnel simply delivered ICGS a new scope of work. ICGS agreed to make the
additions and changes, but indicated that production time-lines would lengthen and that there
15
US GAO Testimony: “Homeland Security – Challenges Facing the Coast Guard as it Transitions to the New
Department”, February 2003. GAO-03-467T
16
US GAO Testimony: “Coast Guard – Preliminary Observations on the Condition of Deepwater Legacy Assets and
Acquisition Management Challenges”, June 2005. GAO-05-651T
16

18. would be additional costs. Faced with an increased “operational tempo” and new mission
requirements, Coast Guard had little choice but to agree. The “partnership” arrangement
transformed quickly into a transactional arrangement with ICGS billing Coast Guard for every
change or modification to the existing agreement, and considerable confusion about what ICGS
had agreed to produce.
One of the best examples of the failed promise of “partnership” was the 123-foot cutter,
one of the first assets to be delivered. Prior to 9/11 the Coast Guard had planned to acquire a
new fleet of fast response cutters to be delivered by 2018. After 9/11, the Coast Guard elected to
modify its existing 110-foot cutter, primarily by adding 13 feet of deck and hull. The new task
order with ICGS called for all 49 existing cutters to be modified. The production and delivery of
these assets quickly became plagued by a series of problems. For one, Coast Guard agreed to an
ICGS proposal to develop a composite hull, a novel, but untested approach to retrofitting the
boat. Soon after the delivery of the first eight 123-foot cutters, testing and review of the patrol
boat’s structure revealed hull buckling, potentially compromising the viability of the asset. In
addition, the Coast Guard identified 22 of the 110-foot cutters that, due to unexpectedly severe
hull corrosion, required additional inspection and repair separate from the Deepwater
modification plans. Further, Coast Guard officials had four cutters in operation in the Persian
Gulf, which made them unavailable for modification.17 Both sides expressed confusion about
the status of the cutter modifications, the hull repair program, and the overall schedule. By 2006,
the Coast Guard decided to dry-dock the 123-foot cutters, decommissioning them from the Coast
Guard fleet.18
17
US GAO Report. March 2004. “Contract Management: Coast Guard’s Deepwater Program Needs Increased
Attention to Management and Contractor Oversight”. GAO-04-380
18
U.S. Coast Guard Press Release. Nov. 30, 2006. “Coast Guard Suspends Converted Patrol Boat Operations”.
http://www.piersystem.com/go/doc/786/138897/
17

19. Both sides got less than anticipated from the first five-year installment of the IDIQ
contract. The Coast Guard faced program delays, higher costs, and received a non-operational
asset. The overall acquisition schedule lengthened from 25 to 30 years and the planned
acquisition costs jumped from $17 billion to $24 billion.19 ICGS faced unexpected renegotiation
costs due to repeated changes to the original agreement, and the reputations of both Northrup
Grumman and Lockheed Martin suffered as a result of perceived poor performance. The
promise of a win, win “partnership” deteriorated into a lose, lose transaction.
What explains this outcome? Some evidence points to the behavior of the Coast Guard –
repeated major changes to task orders and a failure to claim a role in the IPTs. Other evidence
points to the behavior of ICGS – the performance test failure of the composite hull on the 123-
foot cutters and its dominance of the IPTs. Finally, some evidence points to unexpected external
events – 9/11 and its aftermath. In response, both parties lack trust in the other and fear
“defection” moving forward, although neither party is able to determine whether current
outcomes are a result of the strategy and behavior of the other party or exogenous forces outside
either party’s control. Now other forces are at work, most notably more aggressive scrutiny from
an array of overseers (e.g. DHS’s Inspector General, the Government Accountability Office, the
Congressional Research Service). A changeover from a Republican to Democratic majority in
2004 has intensified oversight; Congressional Democrats are particularly incensed by what they
perceive to be mismanagement by both parties, and as a result have pushed the Coast Guard
away from a reliance on ICGS as a systems integrator. At the moment, the Coast Guard is in the
process of standing up its own system engineering and acquisition capacity for Project
Deepwater in an internal entity called the Acquisition Directorate. The Coast Guard remains
19
US GAO Report. April 2006. “Coast Guard: Changes to Deepwater Plan Appear Sound, and Program
Management Has Improved, but Continued Monitoring is Warranted.” GAO-06-546.
18

20. “locked in” with Lockheed Martin and Northrup Grumman to some extent, but they are moving
away from their integrated partnership back towards a piece-by-piece acquisition approach.
Conclusion
The game theory model and illustration of the Coast Guard’s Project Deepwater we
presented so far suggests complex contracting is a dire endeavor. Complex contracts are highly
uncertain, costly to negotiate and execute, and obfuscate accountability. Under the prisoners’
dilemma, win-win cooperation is irrational and lose-lose outcomes most likely. Uncertainty
about nature’s contributions to payoffs mean even the parties in the contract do not know
whether contract outcomes stem from misfortune, the other party’s malfeasance, or their own
mismanagement. In the case of Deepwater the default response of both Coast Guard and ICGS
is to assume that the other player “defected”. Overseers, notably Congressional oversight
committees, have made a similar determination and have taken steps to push Coast Guard into a
“defect” strategy in future rounds. As our analysis shows though, while there’s evidence to
suggest that one or both of the exchange parties are partially at fault, nature played a strong hand
in either producing the negative outcomes or pushing the exchange parties towards a lose, lose
outcome. In moving forward, the default response shouldn’t necessarily be to position Coast
Guard and whatever sellers it engages into a rigid defect, defect posture almost.
Because complex contracts are prone to renegotiation, the “shadow of the future” opens a
wealth of cooperative strategies, allowing contract parties to turn lose-lose conflict into win-win
cooperation (e.g. Heide and Miner, 1992). Moreover, these cooperative strategies enhance
overseer’s ability to hold people accountable in the contract process. In the case of Project
Deepwater, the multi-stage architecture of the contracting process allows for this kind of
19

21. renegotiation. While the projection is that it will take 30 years to deliver all the component
Deepwater assets, the Coast Guard and ICGS did not formally commit to a 30-year agreement.
Instead the contract is structured in five year increments. The asset specific nature of the
products means that the Coast Guard faces a thin market of alternative suppliers, but at a
minimum the overall contract arrangement allows for both exit and renegotiation. The shadow
of the future is real here, and there are significant consequences to both parties in terms of costs
and reputation from spiraling away from a partnership arrangement towards a more antagonistic
arms length transactional relationship. In addition, Congress’ increasing oversight and
involvement in the Deepwater program demonstrate how authorizers can take steps to change the
rules of the game. At present, Congress is pushing the Coast Guard towards more of a prisoner’s
dilemma game, away from a cooperative game, but it doesn’t have to be so. Congress could
instead take steps to foster cooperation albeit while increasing the level of information available
to all parties to insure accountability. For example, rather than forcing Coast Guard to move
away from an integrated relationship with ICGS to a more differentiated purchasing
arrangement, Congress instead encourage Coast Guard could build on recent efforts to enhance
Coast Guard’s role in the IPTs and rely more extensively on third party certification of product
design and delivery. One of the primary reasons to take such steps is that there are significant
opportunities to capture knowledge and information from the first round and apply it to
subsequent rounds of contracting. The practice of complex contracting need not be so dire.
20

22. References
Akerloff, G. (1970). The Market for Lemons: Qualitative Uncertainty and the Market
Mechanism. Quarterly Journal of Economics, 84(3): 488.
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Brown, T., Potoski, M., and Van Slyke, D. (2008). Trust and Contract Completeness in the
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(2): 332-337.
Heide, J., and Miner, A. (1992). The Shadow of the Future: Effects of Anticipated Interaction
and Frequency of Contact on Buyer-Seller Cooperation. Academy of Management Journal 35
(3): 265-291
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Hutton, J. (2008). Presentation on Contracting to MPA students, Maxwell School of Citizenship
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the new governance. New York, NY: Oxford University Press.
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21

23. Williamson, O. (1996). The Mechanisms of Governance. New York: Oxford University Press.
22

24. Figure 1: The Contracting Game
Phase I: Phase II: Phase III: Phase IV:
Negotiation Strategy Selection Nature Payoffs
Buyer Seller
Positive (#, #)
Cooperate
Negative (#, #)
Cooperate
Positive (#, #)
Defect
Negative (#, #)
Incomplete
Contract
Positive (#, #)
Cooperate
Negative (#, #)
Defect
Positive (#, #)
Defect
Negative (#, #)
23

25. Figure 2: The Impact of Nature
Phase II: Phase III: Phase IV:
Strategy Selection Nature Payoffs
Buyer Seller Buyer Seller Mutual Gain
Positive 3+2=5 3+2=5 10
Cooperate
Negative 3 + -2 = 1 3 + -2 = 1 2
Cooperate
Positive 1+2=3 4+2=6 9
Defect
Negative 1 + -2 = -1 4 + -2 = 2 1
Positive 4+2=6 1+2=3 9
Cooperate
Negative 4 + -2 = 2 1 + -2 = -1 1
Defect
Positive 2+2=4 2+2=4 8
Defect
Negative 2 + -2 = 0 2 + -2 = 0 0
24

26. Appendix I: The Basic Prisoner’s Dilemma Game
Buyer Strategy
Cooperate Defect
Cooperate 3, 3 1, 4
Seller
Strategy
Defect 4, 1 2, 2
25