Factor Choice Distortion under Cost-Based Reimbursement

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Abstract
We study a setting in which a firm faces commercial and cost-reimbursed products, and, following Rogerson (1992), examine the factor choice distortions that are induced by the cost-based reimbursement arrangement. The firm's technology is separable, which allows us to rationalize fully an ABC procedure (given constant returns to scale) and also allows us to document whether the distortions occur in the direct or indirect subcost functions. The location and magnitude of the distortions depend on the precise costing procedure, but the preference for an ABC versus traditional procedure is far more subtle. Absent constant returns, any (linear) accounting procedure invites factor distortions because of the cost-reimbursement feedback, but the economic impact of these distortions depends on the technology, the relative prices, and the costing procedure.

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