Contractor
		Not participate	Participate	Opportunity Loss / Gain
Orderer	Big success (+20)	( +15, 0 )	( +10, +5 )	-5
	Success (+10)	( +5, 0 )	( +5, 0 )	0
	Failure (+0)	( -5, 0 )	( 0, -5)	+5

		Contractor
		Not participate	Participate	Opportunity Loss / Gain
Orderer	Big success (+20)	( +15, 0 )	( +12, +3 )	-3
	Success (+10)	( +5, 0 )	( +2, +3 )	-3
	Failure (+0)	( -5, 0 )	( -8, +3)	-3

Now we would like to move from the performance-based payment case to the fixed payment case. In case of the fixed payment, the income of the contractor, i.e. the payment of the orderer, is predefined in the contract before the project starts. And whether the project finishes in success or failure, the orderer has to pay the predefined amount of money to the contractor. Let's try to draw the same matrix as in case of the performance-based payment case.　We assume the contractor always get paid 8 units since they always have to invest 5 unit of their resources in order to accomplish this project.

In the business world it seems that the performance-based system is introduced not only into the personnel evaluation but also into the order placement process in general. In the personnel evaluation the performance-based system means that the salary of employees are calculated based on what they have achieved for a defined period. In case of the order placement process, the performance-based system functions as follows. A company orders some project tasks to a contractor. The payment to the contractor is not defined in advance. After the project finishes, how much benefit the orderer has gained from the project is calculated. The contractor gets paid the defined percentage of the calculated benefit.

Let's take the example of a cost reduction project. A company would like to reduce the manufacturing cost by the renewal of manufacturing facilities and starts a project for cost reduction. The company orders a new manufacturing facility and its installation to a contractor. In the contract the company defines, for example, 40% of the project benefit shall be given to the contractor. When the project finishes successfully, the orderer calculates that 50 million yen of manufacturing cost will be reduced. So the contractor gets paid 20 million yen from this project. This is the performance-based system in the order placement process.

This system looks like favorable to the orderer since the orderer has to pay nothing to the contractor when it gains no benefit from the project. But if you analyze this system by using the game theory, on the contrary, you will find that the costs will increase in the long run. Just like the performance-based system in the personnel evaluation, this system functions quite differently from its first good impression. Let's start the analysis of the performance-based system in the order placement process.

When we adopt the game theory as analysis tool, we always have to assume the following two points. (1) Every player participating in the game behaves rationally and (2) tries to maximize its own benefit. In addition, we have to assume some other points concerning the project itself. The project costs money for the players. If the orderer proceeds the project without help of any contractors, they have to spend their own financial and human resources. If a contractor participates in the project, the contractor has to invest its own human resources into the project. We would like to assume that the cost doesn't vary whether the same project tasks is done by the orderer alone or by the collaboration between the orderer and the contractor. Regarding the same project tasks, the orderer spend, for example 5 units of its resources when they have no support from the contractor. When the contractor participates in the project and do the same project tasks instead of the contractor, we assume that it also costs the same 5 units of the contractor's resources.

Concerning the calculation of the project benefits, we assume that it is the orderer who calculates it. It would be nonsense to assume that the contractor calculates the project benefits. If the contractor can calculate the project benefits by themselves, they try to calculate it as much as possible in order to maximize their income. So we assume that the orderer calculates the project benefits that becomes the basis for calculating the income of the contractor.

Based on the assumptions described above, we would like to analyze the performance-based order placement by the game theory. The contractor has two alternatives, participating in the project or not. If the contractor decides not to participate in the project, they naturally can't get any income from the project and don't have to spend any resources for the project. Regardless of the actions taken by the orderer, the contractor wins nothing and loses nothing in this case. On the contrary, if the contractor decides to participate in the project, the contractor always loses, for example, 5 units resources in order to proceed this project while their income from the project varies widely depending on how much benefits the orderer will be able to get from the project.

In order to facilitate the calculation of benefits, we would like to assume the contractor always loses 5 units resources when they participate in the project. This means, if the orderer proceeds the project without support of the contractor, they also lose 5 units resources to finish the project. And we assume three results of the project benefits. (1) big success: the orderer gains 20 unit benefits from the successful end of the project, (2) success: the orderer gains 10 unit benefits from the project and (3) failure: the orderer gains nothing from the project. And we assume that 50% of the benefits will be the income to the contractor.

In case of big success, the contractor gets 50% of 20 unit benefits, i.e. 10 unit and has to invest 5 units of its own resources to do the project tasks. As a result, their income will be 5 units (= 10 minus 5). In case of success, the contractor gets 50% of 10 unit benefits, i.e. 5 unit and has to invest 5 units to do the project tasks. As a result, their income will be 0 units (= 5 minus 5). In case of failure, the contractor gets nothing while they have to invest 5 units to accomplish the project tasks. As a result, they lose 5 units (= 0 minus 5).

From the viewpoint of the orderer, in case of big success, they get 50% of 20 unit benefits, i.e. 10 unit and lose nothing because everything is done by the contractor. As a result, they get 10 unit benefits (= 10 minus 0). In case of success, they get 50% of 10 unit benefits, i.e. 5 unit and lose nothing. As a result, they get 5 unit benefits (= 5 minus 0). In case of failure, they get nothing.

If the contractor doesn't participate in the project and the orderer accomplishes the project by itself, the ordere always monopolizes the benefits of the project but always has to invest their own resources by 5 units. As a result, in case of big success, they gain 15 units (= 20 minus 5), in case of success, they gain 5 units (= 10 minus 5) and in case of failure, they lose 5 units (= 0 minus 5).

Let's draw the matrix in order to summarize these results. On the left hand, we see the alternatives for the orderer. The orderer has three alternatives of the project result. On the top, we see the alternatives for the contractor. The contractor either participate in the project or not. In this matrix we added a new column called "Opportunity loss/gain". This column shows the opportunity loss or gain for the contractor. When the contractor doesn't participate in the project, they gain or lose some amount of their resources compared to the case when they participate. For example, if the project is expected to finish in a big success, the contractor will lose 5 unit benefits when they miss the opportunity to participate in the project. On the contrary, if the project is expected to finish in a failure, the contractor will be able to avoid losing 5 unit resources by refusing to participate in the project. This opportunity loss / gain has a definitive influence upon the decision making of the contractor. So we should carefully watch the numbers on this column.

If the contractor doesn't participate in the project, the situation doesn't change at all for the orderer. So the figures on the "Not participate" column has no change compared to the performance-based payment case. If the contractor participates in the project, things change widely. In case of big success, the orderer can monopolize 20 unit benefits but has to pay the fixed payment by 8 units to the contractor. As a result, the orderer gains 12 unit benefits (= 20 minus 8). In this case, the contractor gets 8 units income but invest 5 units of their resources to accomplish the project tasks. So the contractor' gain is 3 units (= 8 minus 5). In case of success, the orderer can monopolize 10 unit benefits but has to pay the fixed payment. As a result, the orderer gains 2 units (= 10 minus 8). For the contractor, the situation is always the same, 3 units gain. In case of failure, the orderer has to pay 8 units without any benefit.

Now we would like to compare these two matrixes. It is not so meaningful to compare the "Not participate" cases. So we would like to focus on the case when the contractor participates in the project. Which payment system is more favorable for the orderer? And which payment system is more favorable for the contractor?

First, we would like to take the viewpoint of the contractor. When we consider this viewpoint, the "Opportunity loss/gain" column is critical. In case of the performance-based payment, the contractor had better participate in the project only when they can expect the project finishes in a big success, because only in case of big success, the "Opportunity loss/gain" column shows the opportunity "loss". The contractor is motivated to participate in the project only when they expect the big success of the project. On the other hand, in case of the fixed-payment system, the contractor always had better participate in the project because the "Opportunity loss" columns always shows "loss". The contractor is always motivated to participate in the project.

In case of the performance-based system, the contractor is motivated to participate in the project only in case of big success expectation, while, in case of the fixed payment system, the contractor is always motivated to participate in it. Here we should ask ourselves the following question. In which case will the competition for getting the order from the orderer be more intensified? Of course, the contractors will compete more severely with each other in case of the fixed payment system because the number of potential participants is larger in case of the fixed payment than in case of the performance-based payment. The more intensified competition means that the orderer has more opportunity to get more room for discounting the payment to the contractor.

In case of the performance-based system, the contractors will try to participate in the competition only when they can expect big success. If we assume that the expectations of most contractors are similar to each other, the orderer will not be able to get any contractor for the projects with bad outlook. As a result, the orderer will have to increase significantly the percentage of the project benefits that will be paid to the contractors. If we assume that the expectations of most contractors are different from each other and if each contractor has different opinion concerning whether the project will finish in success or not, the orderer will always have less bidders in every project than in case of the fixed payment system. As a result, the orderer will have to increase the percentage of the project benefits that will be paid to the contractors.

You can't argue against this by saying that in case of the performance-based payment both the orderer and the contractor are strongly motivated to maximize the project benefits. This counterargument says that there is a kind of win-win relationship between both parties in case of the performance-based payment system. But this counterargument is valid only when the project actually starts. The problem of the performance-based system is that the contractor is motivated to participate and start a project only when they expect the good results from the project. We must remember that the potential contractors have always freedom to refuse the bid. The question is whether the orderer can start projects or not. You can't discuss the win-win relationship until the project actually starts. The performance-based system demotivates potential contractors to participate in the projects in some cases. This is one of the critical defects of the performance-based system.

In case of the fixed payment system, the bids for every project are nearly equal to so-called "perfect competition" because the potential contractors can always expect gain (positive figure) in participating in every project. So the orderer can expect the price discount through the price negotiation process before making a contract. It is true that the orderer must pay the fixed price even when the project fails. This motivates the orderer to maximize the benefits of the project more eagerly than in case of the performance-based payment system, because in case of the performance-based payment system, the more benefits the project brings, the more the orderer has to pay to the contractor. When you compare the two matrixes, you can see that in case of big success, the orderer can get more benefits in the fixed payment system than in the performance-based system. This means that the orderer makes efforts to achieve even bigger success than "big success". On the other hand, it might seem at the first glance that the contractor is less motivated to achieve success in the projects that has already started. But if the contractor tries to save their efforts to minimize their efforts invested into the project, what will happen? The orderer will never offer any bid to such a lazy contractor. The orderer can always eliminate any contractor from the candidate list because the bid in the fixed price system is always nearly equal to the perfect competition and you can easily find another contractor that are motivated to participate in the project. As you see, in case of the fixed payment system, the contractors principally have no choice to refuse the orderer's bid at their own will because it is always favorable for the contractors to participate in the bid. In other words, the orderer can oblige the potential contractors to participate in the bid. This leads the price negotiation power of the orderer and reduces the project costs in the long run. The phrase "in the long run" means that if you see the total cost of several projects, the fixed payment system is more favorable to the orderer than the performance-based payment system. In case of the performance-based payment system, the contractors have freedom to refuse the bid. They have freedom to choose only the cream of the cream. In case of the projects with bad outlook, the orderer has to make big efforts to find out the candidates. If they can't find the candidates, they have to offer better conditions to the potential contractors.

For the shortsighted people on the orderer side, the performance-based payment system looks more favorable than the fixed payment system at the first glance, because, if you focus only on one project, the orderer will never lose anything as long as a contractor participates in the project. In case of the fixed payment system, they have possibility to get minus 8 in case of failure. But if you take two and more projects into consideration, you will get a totally different conclusion. Among several projects, the potential contractors will choose only the projects with good outlook. This eases the competition for the potential contractors and makes the whole situation more favorable for the contractors. Is it realistic to assume that a orderer has only one project? When the orderer has more than one projects, the fixed payment system is always more favorable to the orderer and less favorable to the contractors than the performance-based payment system.

Only when we have a clear outlook about the project results, the performance-based payment system will work well. But in reality only limited number of projects will give us a clear outlook. Concerning most of the projects, the orderer can't tell whether and how much they will succeed or not. Even when the orderer can't anticipate clearly the project results, why can the contractors anticipate them? Then what happens if the contractor introduces the performance-based payment system? The orderer tries to show the expected benefits of projects as much as possible while the contractors know well that such outlook can't be trusted. So the contractors participate only in the projects that they can have enough information in advance. But in the end it is the orderer that estimates the benefits of the project. It is only when the contractor knows that the orderer is obliged for certain reasons to estimate the project benefits as much as possible when the project ends in the future that the contractor participates in the bid. For example, when the top management of the orderer strongly expects the success of the project or when the project failure will surely lead to the terrible personnel evaluation for the orderer. Only when the contractor has a detailed knowledge of these kinds of internal information regarding the decision-making conditions, they can decide which projects they should participate in. In order to get such internal and contextual information of the orderer, the contractors must already have close relationship with the orderer. This means that this contractor already has an exclusively superior position compared to the other potential contractors. In the future this exclusively superior position makes this contractor indispensable partner for the orderer. The orderer will have to pay exclusively much money in order to accomplish some projects that requires this contractor. Under the performance-based payment system, there is high possibility that a certain contractor gets a lock-in position in the bids of projects in the long run.

From these unfavorable outcomes of the performance-based payment system for the orderer, we can identify only two occasions where this system provides benefits to the orderer. (1) In case that the contractor is a group company of the orderer. (2) In case that the contractor can get benefit beside the projects. When the contractor is part of the orderer company's group, the contractor can't refuse the bid. In this case, the orderer has no risk that no contractors participate in the bid. And when the contractor can get paid beside the project itself, they are motivated to participate in the bid even though they might invest their resources in vain into a failed project ('-5' units in the matrix). For example, in the case of the cost reduction project just as described in the beginning of the essay, even when the contractor gets little benefit from the project itself, they still have the repeat order from the orderer. And by getting the repeat order, the contractor can gain the benefits for a long period from the cost reduction that was produced by a successful project in the past. Only in these two cases, the performance-based payment system can produce win-win situation for orderer and contractor. By the way, if we combine these two conditions, it looks very similar to keiretsu system in Japan. In keiretsu system, the affiliate parts manufacturers are always obliged to participate in the bid for the cost reduction projects. In addition, they can get only fixed amount of money whether they accomplish the projects successfully or not since they can get the repeat order of manufacturing parts from the parent company. Through the repeat order, the affiliates can gain benefits that were produced by their own efforts in the past projects for cost reduction. The situation of keiretsu system is more unfavorable to the contractors than that of the performance-based payment system because the contractors have no choice to refuse the bid and have only the fixed income in keiretsu system. But as long as the contractors participate in the group of keiretsu, they have no risk of bankruptcy. This is how the keiretsu system works especially in the automobile industry in Japan. If you can't expect the two conditions mentioned above, the performance-based payment system will increase the total cost of all projects since the competition becomes easier and easier to the contractors.

Maybe there is one more case when the performance-based payment system works perfectly. It is in case that the oderer has extremely strong buying power in the industry. No potential contractors can neglect the bid from the largest company in a certain industry. We can say that the largest company in a certain industry can oblige the contractors to participate in their bids. When the orderer doesn't have strong buying power in the industry, the contractors can exploit the orderer when the orderer proposes the performance-based payment system because the contractors will participate in the bid only when they can exploit the orderer. In case of such weak orderers, the potential contractors might propose the performance-based payment system even from their side in order to get the opportunity of exploiting such orderers, instead of waiting for the proposal of the performance-based payment system from the side of the orderer.

Something new always looks good for the neophilia, who prefers something new unconditionally to something old. The performance-based payment system in the ordering process is something new that fascinates every neophilia in the business world. But it doesn't consist in its freshness whether something is right or wrong. We must have good insight to discern right and wrong regardless of its freshness. I think this is a kind of common sense but you can always find somebody lack of common sense.