Procurement Contract Design in Global Infrastructure Projects: The Impact of Loss Aversion

Abstract

A growing number of governments are persuading private firms to build and operate infrastructure projects for them. Since the initial contract between the government and firm is based on forecasted demand, the government can renegotiate to adjust it after demand is realized. We use stylized modelling to study whether the government should offer the firm a flexible contract that allows ex post renegotiation or a rigid contract when the private firm is loss-averse. Our model results show that the government’s decision depends on two key factors: demand uncertainty and the firm’s loss aversion. We further investigate whether the government should renegotiate the subsidy or concession period. We find that such a decision depends on the improvement in social welfare after the project transfer. To offer operational insights into the mitigation of the social welfare loss by promoting renegotiation, we discuss three strategies that the government can use: imposing a tax rate, running a competing domestic project, and offering a dollar-based subsidy. We describe the conditions under which these three strategies are conducive to renegotiation as well as their effects on the initial contract.

Keywords: Project Management, Renegotiation, Contract Design, Loss Aversion