Abstract: The clients have increasingly outsourced their IT services from an IT vendor over the last two decades. The IT vendor is considered who has not only private information about its system development capability but also unobservable development effort to the client, and how the client designs the IT outsourcing contract according to a stylized model is investigated. By comparing the cases of symmetric and asymmetric information, our analysis shows that under asymmetric information case, the client can screen the IT vendors who have different system development capability according to the optimal contract menu. Meanwhile, the client has to pay information rent to the IT vendor who has high capability. On the other hand, the client can regulate the development effort of the high capable IT vendor by the optimal contract. In contrast, the low capable IT vendor exerts less development effort under asymmetric information case than that under symmetric information case, which is referred to as under-effort. The under-effort of low capable IT vendor decreases the social welfare and the client’s expected profit. The information rent obtained by the high capable IT vendor reduces the client’s expected profit as well. By increasing the testing time or selecting the high bug-detection rate of IT vendor, the client can decrease the information rent obtained by the high capable IT vendor and mitigate the under-effort of the low capable IT vendor, which reduces the profit loss of the client due to asymmetric information. Data from the IT outsourcing contract between British Columbia, Canada Ministry of Health and IBM are used to verify our results, which provides insights on how to reduce the profit loss for the client in real-world IT outsourcing.

Key words: asymmetric information; moral hazard; screening contract, IT system development; software reliability growth model