Contract Design of Concessions

The concession contract establishes a formal relationship of exchange of service and money between the host government and concessionaire. Ideally, it will specify the obligations and rights of each party under every contingency concerning the future trade, and each party simply follows the specified instructions. This contracting mechanism, however, is flawed due to three problems: moral hazard, incredible commitment, and contractual incompleteness. Moral hazard recognizes the firm´s unobservable and self-interest behavior, incredible commitment recognizes contracting parties´ reneging behavior, contractual incompleteness recognizes that the contractual environment is changing in an unanticipated manner. These problems impede the efficiency and sustainability of infrastructure concessions. This paper applies contract economics to analyze the origins and consequences of these contracting problems, and to evaluate the effectiveness of different contract schemes in solving these problems. The contract analysis method employed is complementary to the risk management method and provides a comprehensive perspective for concession contract design. It can also be applied to other service industries, such as construction services and manufacturing services, among others.