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Less Risk, More Effort: Demand Risk Allocation in Incomplete Contracts

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  • Laure ATHIAS
  • Raphael SOUBEYRAN

Abstract

This 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.

Suggested Citation

  • Laure ATHIAS & Raphael SOUBEYRAN, 2012. "Less Risk, More Effort: Demand Risk Allocation in Incomplete Contracts," Working Papers 12-20, LAMETA, Universtiy of Montpellier, revised Jun 2012.
  • Handle: RePEc:lam:wpaper:12-20
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    File URL: http://www.lameta.univ-montp1.fr/Documents/DR2012-20.pdf
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    References listed on IDEAS

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