Moral Hazard Problem of Construction in Disturbed Areas –An Economic Analysis
An important focus of the economic understanding of situations involving payoffs has been to analyse strategies of parties as they try to obtain an optimal action plan to maximize their payoffs. Game theory ideally involves a number of behavioural and economic concepts, all of which have a role to play in the final conclusion that the game leads us to. The following project seeks to understand the payoffs of parties involved in a peculiarly risky situation as a result of uncontrollable external conditions, which is disturbance in an area due to terrorism or other activities of the like. An attempt has been made to analyse the affinity of the parties to risk in this situation, the peculiarity of the situation also finds a Moral Hazard problem and finally leads us to a few recommendations to help us deal with this situation.
MORAL HAZARD PROBLEM AND EFFICIENT RISK ALLOCATION
The decision to undertake construction activities in disturbed areas of the country as well as involvement of private parties such as contractors for carrying out the activity is essentially a situation which could give place to Moral Hazard problems.
In simpler terms, a Moral Hazard crisis always originates at a point when one party holds back an essential information thus giving place to “Asymmetry of Information” result of this imbalance, the party which does not have access to the information will use every possible means to budget its role to achieve maximum benefit at the least possible cost even if it means using lower value techniques and methods.
Imagine a situation where the government has decided to rope in contractors for the construction of highways in areas which are prone to violent disturbance. The contractors here are private parties, who, owed to the nature of the situation they find themselves in, are inept to acquire anymore information than what the Government and media releases provide them with. These sources of information however, unfortunately almost always fail to give a true picture of the situation, thus leading to asymmetry of information. The contractor, as a result of the information he holds and in the absence of any assurance from his principle will try to finish his work hurriedly, in order to save time and his duration of exposure to threat, thus protecting his life and property or in the most unfortunate situation refuse to work in the disputed area altogether. In a situation in which he agrees to do the project hastily, he increases the risk of future costs to the Government due to shabby work, and so it becomes clear that neither side can benefit optimally from this situation. To avoid such a situation, it becomes extremely important to efficiently allocate the risks that are involved in the undertaking of the project between the parties.
The first party to this contract, i.e the Government’s prerogative is to have the said project completed. They are averse to any kind of risk that they may have to face in the process of construction that would impede the process of construction or cause delay or a holdup. The contractor also, should he choose to do the contract, will be investing extremely valuable long term assets, such as machinery and human labour in the project, and would like to ensure his investments safety. Especially in this situation, where he knows that a threat exists to his work, he would be unwilling to look at the average payoff, and would like to be accounted for each and every loss he has to encounter in the way of his work. In the absence of clauses which ensure him just the same, the risk allocation will be unfair to the Contractor. Burdening one party beyond its capacity to take the risk would mean leaving scope for a beach in the contract.
In the recognition of this situation, the authors of this project propagate the necessity of the inclusion of a ‘compensation clause’ and a ’delay clause.’ Such a clause will be beneficial to both the parties, by giving additional reassurances to the contractor, it would reduce the amount of risk he has to undertake, thus ensuring that he not only enters this volatile contract but also finishes his work with minimum probability of a breach. Therefore, while both the contractor and the government are exposed to the external, unavoidable risk, the compensation clause does little more than efficiently allocate the risk among both these risk averse parties, allowing them to reach an efficient if not optimal situation. The idea is that the government would provide adequate amount of compensation to the grieving party and would allow them a reasonable amount of extension in time to complete the project. However, it is important for the government to make sure that the compensation amount is neither too high nor too low, to avoid a hold up threat. The compensation clause should be included after ascertaining each case differently in terms of cost of project and chances of violence breaking out in the particular region.
In the light of above-mentioned principles the following are recommended-
- In case of peculiar projects undertaken in violent prone regions insertion of a “Compensation clause” becomes essential as it effectively allocates risk and ensures efficient functioning with little or no breakdowns.
- Compensation clause in each contract should be inserted in accordance with the cost of that particular project and the situation in the area.
- “Extension of time in case of delay” clause to further incentivize the contractor to finish the project without resorting to any kind of breach is of relevance.
Author: Swati Bisen
College: Gujarat National Law University, Gandhinagar
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