7.3  Related Literature and Applications

Literature : The literature on intertemporal incentive problems under moral hazard is huge but most of it assumes separability between the benefits and costs of working on a project in different period stressing the role of history dependent contracts to smooth incentives.40

The seminal paper on intertemporal effort allocation in the presence of incentive problems is Lambert (1984), who showed that when the project has time separable, mutually independent returns each subperiod, a risk-averse agent will smooth his effort choice to reduce variance in his consumption. This is in contrast to the first-best, where each period's effort is independent of previous periods' output.

Laffont and Tirole (1993, Chapter 8) proposed an adverse selection model with repeated auctions of incentive contracts which shares many features of our model, most noticeably the shift towards higher powered incentives over time. An incumbent firm invests in period 1 but, because of contract renewal, may lose the benefits of its investment if it is not granted the new contract for date 2. They particularly focused on the necessary bias towards the incumbent as an incentive tool to secure investment and show that this bias matters all the more that investment is not easily transferable. A major result of their analysis is also that incentives to invest are fostered with incentive schemes which are higher powered over time. Our pure moral hazard model can be viewed as providing a simplified version of the same insight.

Higher effort over time is also found by Ray (2007) who studied the value of interim performance evaluations and their effect on the intertemporal effort allocation. He built a two-period model in which both periods' efforts contribute only to the single final outcome and first-period effort is useless unless second-period effort also occurs. Performance evaluations increase efficiency by providing the option to end projects with low early returns and the agent to work harder in later stages because of the risk of termination. This result holds under a variety of scenarios: When the worker has unknown ability, when the outside options vary with output, and in an agency context with a risk-neutral principal and a risk-averse agent.

In non-agency settings different insights are obtained. In line with the career concerns literature, Lewis (1986) shows that reputational concerns lead firms to choose higher effort in earlier stages of their procurement contract in order to send favorable signals to the principal regarding their productivity and avoid that project be terminated too soon.

Dewatripont and Legros (2005) argue that ex ante competition between potential consortia may limit the extent of cost overruns and that introducing a third-party (typically outside shareholders or creditors) in a PPP contract may improve monitoring which limits cost overruns as well. 

Applications: Empirical evidence on effort allocation in long-term projects shows that effort rises over time. Projects within firms often run beyond deadlines and most resources are increased towards the final stages (see Marshall and Meckling (1962) and Mansfield et al. (1995)). Actual costs often significantly exceed cost estimates used to decide whether public projects should be built.

PPPs are not immune to cost overruns, though no clear evidence exists as to whether cost overruns under PPPs are more or less likely than under traditional procurement. In the UK, with traditionally procured contracts, in 73 per cent of central government's construction projects the price to the public sector had exceeded the contractors' tender price and the project ran over budget; actual costs were between 2 and 14 per cent above estimates. The equivalent figure with PFI was 22 per cent although that was due to the private companies bearing the cost increase rather than the cost increase not occurring (NAO, 2003b). Examples of cost overruns under PPP also include the disastrous case of Metronet, the private tube contractor for London Underground, whose cost overruns lead it to bankruptcy.

Whilst risk allocation in PPPs generally forces the contractor to bear a significant part of the construction and operational risks, the actual risk allocation may differ from what was originally planned. Government are providers of last resort and contractors are aware that public authorities cannot afford prolonged service disruption. The retendering of a PPP contact is a long and costly process. Also, as the case of London Underground points out, a market for secondary contracts may not always exist. In fact very few PPP contracts have been pre-maturely terminated. The Channel Tunnel Raillink is one example of the government bailing out the PPP contractor. More generally, empirical evidence supports that risk allocation in practice often departs from what laid out in theory (see e.g. Lobina and Hall, 2003). As stressed by The World Bank, "whether PPPs perform better than full provision by state-owned enterprises depends in particular on whether performance risk is effectively shifted from taxpayers to the private shareholders of the company that enters into a concession-type arrangement" (World Bank, 2002: 23-24).

_____________________________________________________________________________________________________
40See Laffont and Martimort (2002, Chapter 8) and the references therein.