Study of Optimal Contract Under Asymmetric Information
The opportunism and information asymmetry between the two parties of a contract alteration give rise to the phenomenon of hold up and underinvestment, as well as the moral hazard problem of hiding information from the other party. This article built up th
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Study of Optimal Contract Under Asymmetric Information Ping Li and Hong-zhi He
Abstract The opportunism and information asymmetry between the two parties of a contract alteration give rise to the phenomenon of hold up and underinvestment, as well as the moral hazard problem of hiding information from the other party. This article built up the optimal contract model under asymmetric information by using the principle-agent theory and studied the above problem. The article proved that, under the conditions that the contractor hides information, the optimal contract would decrease the special purposed investment levels, prolong the time limit of the engineering project, and decrease the owners’ utility. Keywords Contract alteration • Hidden information • Information asymmetry • Project management
36.1 Introduction Large engineering projects have characteristics such as long time limits, huge investment and complex technologies and involve various uncertain factors such as natural conditions, design alteration and the revision and abolition of laws and regulations. Engineering contract is a typical incomplete contract. In the standard project contract samples both home and abroad, conducting negotiation and contract alteration under uncertain natural condition types is permitted (China National Association of Engineering Consultants/International Federation of Consulting Engineers 2003; Ministry of Construction of The People’s Republic of China and Commerce 1999).
P. Li () • H. He Department of Engineering Management, Luoyang Institute of Science and Technology, Luoyang, China e-mail: [email protected] E. Qi et al. (eds.), The 19th International Conference on Industrial Engineering and Engineering Management, DOI 10.1007/978-3-642-37270-4 36, © Springer-Verlag Berlin Heidelberg 2013
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During the negotiation of contract alteration, the position of the contractor is changed due to the magnitude of special purposed investments in the early stage. Usually the more investment the poorer the position of the contractor is in. Under such circumstances, the conduct of hold up is produced if the owner possesses the contractor’s production surplus by taking advantage of the better position in negotiation and makes the contractor under-invest (Hart and Moore 1994; Kultti and Takalo 2002). As for the change of natural conditions, the contractor usually has information advantage. By using information advantage, the contractor may hide the disadvantageous change of natural conditions and possess the owner’s production surplus under the drive of profit. Moral hazard risk is thus produced. The design of optimal contract that overcomes the act of hold up and moral hazard becomes an important research topic. Information asymmetry between the two parties of a contract and opportunistic behavior are the final reasons for the act of hold up and moral hazard. Moral hazard includes types of hiding actions and hiding information. The moral hazard that arises from the alteration processes of engineering project contra
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