Less Risk, More Effort: Demand Risk Allocation in Incomplete Contracts
AbstractThis article investigates the allocation of demand risk within an incomplete contract frame- work. We consider an incomplete contractual relationship between a public authority and a private provider (i.e. a public-private partnership), in which the latter invests in non-verifiable cost-reducing efforts and the former invests in non-verifiable adaptation efforts to respond to changing consumer demand over time. We show that the party that bears the demand risk has fewer hold-up opportunities and that this leads the other contracting party to make more effort. Thus, in our model, bearing less risk can lead to more effort, which we describe as a new example of ‘counter-incentives’. We further show that when the benefits of adaptation are important, it is socially preferable to design a contract in which the demand risk remains with the private provider, whereas when the benefits of cost-reducing efforts are important, it is socially preferable to place the demand risk on the public authority. We then apply these results to explain two well-known case studies.
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Bibliographic InfoPaper provided by LAMETA, Universtiy of Montpellier in its series Working Papers with number 12-20.
Length: 19 pages
Date of creation: Jun 2012
Date of revision: Jun 2012
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Postal: Avenue Raymond Dugrand, CS 79606, 34960 Montpellier Cedex 2
Web page: http://www.lameta.univ-montp1.fr/
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This paper has been announced in the following NEP Reports:
- NEP-ALL-2012-07-08 (All new papers)
- NEP-BEC-2012-07-08 (Business Economics)
- NEP-CTA-2012-07-08 (Contract Theory & Applications)
- NEP-MIC-2012-07-08 (Microeconomics)
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