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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, Universitiy 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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    1. Bennett, John & Iossa, Elisabetta, 2006. "Building and managing facilities for public services," Journal of Public Economics, Elsevier, vol. 90(10-11), pages 2143-2160, November.
    2. Laure Athias & Stéphane Saussier, 2007. "Un partenariat public-privé rigide ou flexible ?. Théorie et application aux concessions routières à péage," Revue économique, Presses de Sciences-Po, vol. 58(3), pages 565-576.
    3. Hart, Oliver, 1995. "Firms, Contracts, and Financial Structure," OUP Catalogue, Oxford University Press, number 9780198288817.
    4. Paul A. Grout & Margaret Stevens, 2003. "The Assessment: Financing and Managing Public Services," Oxford Review of Economic Policy, Oxford University Press, vol. 19(2), pages 215-234, Summer.
    5. Ehrlich, Isaac & Becker, Gary S, 1972. "Market Insurance, Self-Insurance, and Self-Protection," Journal of Political Economy, University of Chicago Press, vol. 80(4), pages 623-648, July-Aug..
    6. Jean Tirole, 1988. "The Theory of Industrial Organization," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262200716, May.
    7. Matthew Ellman, 2006. "Does privatising public service provision reduce accountability?," Economics Working Papers 997, Department of Economics and Business, Universitat Pompeu Fabra.
    8. Laure Athias, 2009. "Responsabilité politique et design contractuel des Partenariats Public Privé," Revue économique, Presses de Sciences-Po, vol. 60(4), pages 1011-1021.
    9. repec:hrv:faseco:30727607 is not listed on IDEAS
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