Principal-Agent Model of Risk Allocation in Construction Contracts and Its Critique

Abstract

Incentives are widely used in construction procurement to motivate the contractor to make cost-reduction efforts. How to choose the right incentive intensity is a critical decision in construction procurement. In this regard, the principal-agent theory has been highly influential in theory and practice alike. However, this research argues that this theoretical model may lead to a biased decision. To demonstrate this point, this research draws on its modeling technique to analyze a standard pain-gain sharing arrangement in construction contracts, finding that taking no account of contract breakup hazards will result in underuse of incentives. When the outturn cost also depends on the contractor’s effort, high-powered incentives can better tap into the contractor’s efficiency improvement potential. The additional profit resulting from efficiency savings can serve as a buffer for downside cost shocks with the effect of reducing the likelihood of contract breakup. This benefit will make it desirable to use incentives more intensively than what is suggested by the principal-agent theory.