This article investigates the allocation of demand risk within an incomplete contract framework. 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.
Less risk, more effort: demand risk allocation in incomplete contracts
14 January 2014