Optimal Incentive Contract with Risk-Neutral Contractor

Abstract

Incentive clauses within contracts, referred to as incentive contracts in this paper, based on a sharing of the project outcome are regarded as an important vehicle to align contractor interests with that of the owner. However, discussion is ongoing as to what is the optimal incentive arrangement. This paper derives an optimal incentive contract for a risk-neutral contractor; the owner may be either risk averse or risk neutral. An incentive is established based on a sharing of a project’s equivalent monetary outcome (expressed relative to a benchmark or target that is desired by the owner), while aligning the contractor’s interests with those of the owner. The derivation is based on solving an optimization problem. The paper shows that at the optimum and expressed relative to the target, any favorable or adverse outcome associated with both the contractor’s effort and events beyond the contractor’s influence should, respectively, be wholly received by or wholly borne by a risk-neutral contractor. Practitioners were interviewed to validate this result. This paper gives an original solution to the optimal sharing problem in incentive construction contracts, contributing to current practices in contracts management. The solution follows an ordered argument and is usable by practitioners. Additionally, this paper extends agency theory on risk-averse principals. This paper will be of interest to academics and practitioners concerned with the design of incentive contracts.