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Essays on contracting in the construction industry

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Essays on contracting in the construction industry

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Content ESSAYS ON CONTRACTING IN THE CONSTRUCTION INDUSTRY by Surajeet Chakravarty A Dissertation Presented to the FACULTY OF THE GRADUATE SCHOOL UNIVERSITY OF SOUTHERN CALIFORNIA In Partial Fulfillment of the Requirements of the Degree DOCTOR OF PHILOSOPHY (ECONOMICS) August 2002 Copyright 2002 Surajeet Chakravarty R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. UMI Number: 3094312 UMI UMI Microform 3094312 Copyright 2003 by ProQuest Information and Learning Company. All rights reserved. This microform edition is protected against unauthorized copying under Title 17, United States Code. ProQuest Information and Learning Company 300 North Zeeb Road P.O. Box 1346 Ann Arbor, Ml 48106-1346 R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. UNIVERSITY OF SOUTHERN CALIFORNIA THE GRADUATE SCHOOL UNIVERSITY PARK LOS ANGELES, CALIFORNIA 90089-1695 This dissertation, written by S L J / ? A 7 £ £ 7 ' C j - f A K R A i / A R T y under the direction o f h i s dissertation committee, and approved by all its members, has been presented to and accepted by the Director of Graduate and Professional Programs, in partial fulfillment of the requirements for the degree of DOCTOR OF PHILOSOPHY Director Date August 6 , 2002 Dissertation Committee Chair R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. i Acknowledgment Various people have contributed in the realization of this dissertation. I would like to begin by acknowledging my teachers. My special thanks go to Herbert Dawid and Eric Talley, who have provided encouragement and made numerous suggestions that have enriched my work and given it clarity. To Isabelle Perrigne and Jennifer Arlen I also give my appreciation. Many thanks are due to my friends and family members who in their various ways have provided stimulation and have inspired me. I especially would like to thank Didi, Moudidi, Sripad, Whitney and Pishaemoshai. I am indebted to my advisor, Prof. Bentley Macleod, who has shown enormous patience, given his time freely and has provided insight which has benefited my understanding of contracts and economics. Finally, I would like to thank Ma and Baba for their unquestioning support and love. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. Table of Contents A. Acknowledgments i B. Abstract iv 1. Law and Economics of Contracting 1 1.1 Introduction 1 1.2 Construction Industry 2 1.2.1 Overview 2 1.2.2 Institutions 5 1.2.3 Players 7 1.2.4 Construction Process 13 1.2.5 Contracting 13 1.2.6 Changes 25 1.3 Ingredients for Disputes 30 1.3.1 Expectation and Disappointments 30 1.4 Dispute Resolution 31 1.4.1 Arbitration 31 1.5 Law and Economics of Contracts 32 1.5.1 The Agency Relationship 33 1.5.2 Legal Doctrines in the Construction Industry R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. iii 37 1.5.3 Contract Formation 38 1.5.4 Material Breach 42 1.5.5 Liquidated Damages 47 1.5.6 Remedies for Contract Breach 49 1.6 Conclusion 58 2. Uncertainty and Risk in Hold-up Model 60 2.1 Introduction 60 2.2 Decision Making under Uncertainty 63 2.3 Under Investment Problem Under Investment Problem 67 2.3.1 Bilateral Trade 68 2.3.2 Joint Ownership 75 2.4 No Trade Result 80 2.4.1 Nash Equilibrium under Uncertainty 82 2.5 Conclusion 88 3. Construction Contracts: A Cost Overrun Model 90 3.1 Introduction 90 3.2 Construction Contracts 95 3.3 Explanation 98 R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 3.4 Literature 99 3.5 Model 102 3.5.1 Optimal Investment 109 3.5.2 Owner's and Contractor's Problem 110 3.5.3 Endogenous Anticipated Cost 123 3.5.4 Impossibility Doctrine 125 3.6 Conclusion 127 References 129 R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. Abstract Writing contracts is expensive. Due to this cost, agents often leave contracts incomplete. The cost of writing contracts increase as complexity of the transaction increases. Complexity and cost of contracting affects the type of contracts and also the contractual relationship. Incompleteness in the contract also leads to inefficiencies in the trade and also increases the role of law. In the first essay, I discuss and analyze contractual relationship in the construction industry. I look at the legal rules that are prevalent in the industry and show that the most legal rules used are efficiency based. I discuss contract formation, liquidated damages, material breach, and remedies and find that all these doctrines used are such that the total trade surplus is maximized. Though most doctrines are based on the economic efficiency principle there are a few rules that are based on fairness. In the second essay, I study risk and uncertainty in contracts. Contractual relationships are often fraught with uncertainties. And how do modeling uncertainty rather than risk change results? This question is answered by analyzing three different contracting situations. While in case of contracts for bilateral trade there is no difference between risk and uncertainty, if the contracts are written for joint ownership then having uncertain agents may result in no renegotiation but with risk averse agents R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. there always renegotiation. Lastly a possibility of no trade is shown if agents are uncertain. In the last essay, I analyze how complexity affects contracting. Complexity is an important issue in contracting and this is evident in the construction industry. Large number of contracts ends up in disputes and as a result the damages imposed by the courts play an important role in the effort made by the agents. The optimal damage rule is characterized. Expectation damage is optimal, but if the contractor has all the bargaining power reliance damages does better. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 1 1 Law and Economics of Contracting in C onstruction Industry 1.1 Introduction When two parties make an agreement to trade in the future, there arise two questions of academic interest. The first question concerns what type of agreement is made between the parties and the second question is how the contracting parties will respond to the written or oral agreement between them. Economics tries to address which type of contract maximizes the social value of the trade between two participants. The law, on the other hand, is more focussed on which rules and regulations facilitate trade and contracting between the two parties. Contracts play a dual role in a relationship. They first enable the con tracting parties to share risks from uncertain income streams as analyzed in implicit contract literature in Rosen (1985) and in principle agent literature discussed in Hart and Holmstrom (1987). Secondly contracts help to avoid hold up in any relationship. In recent decades the latter role has gained much importance as economists have analyzed contracts as instruments to avoid hold-up. The hold-up literature is concerned with economic relationships R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. with the following characteristics a) both parties make relationship specific investments, b) the contract written is incomplete and lastly c) the contract can be renegotiated if both parties agree. The relationship specific invest ment generates a rent for the parties while they are in the relationship. This rent or surplus is there for the parties to bargain over. The bargaining power of either party determines how much of the surplus they get. Due to the bargaining the contracting parties might not enjoy the full returns of the investments they make. This threat of bargaining posed by one party to the other is what Oliver Williamson (1985) termed as hold-up. Due to this threat contracting parties will invest less than the efficient amount of investment. 1.2 Construction Industry 1.2.1 Overview In 1992, the Census of Construction Industries reported that there were nearly 2 million businesses operating in the U.S. construction industry. Of them 1.3 million are proprietorship and partnerships without any payroll. Among the firms with payroll 50 percent of them are firms with fewer than five employees. The rest of them contribute to about 80 percent of the R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 3 value of construction industry. In 1993 there were 598,255 construction shops employing a total of 4 million people. Of these shops about 83 percent of them had fewer than ten employees. This industry has grown very slowly. Construction firms vary in size. There are many small “mom and pop” firms with very low capital, which primarily participate in alterations and small scale projects. In these firms, the owner and his family members play all roles, including estimator, installers and book keepers. Market entry for such firms is relatively easy as it involves low capital investments required. Licensing and performance bonds are the only type of entry barriers which exist. The low barrier to entry is an incentive for many entrepreneurs to start there own low capital firm. In these firms productivity is relatively low, related mainly to individual hourly outputs. This often leads to these low capital intensive firms operating with thin profit margins. Compared to these small firms there are firms employing hundreds of employees. Such firms may be privately or publicly owned. The type of con struction these firms enter into are large residential and commercial proper ties. Unlike the smaller firms, the large firms are departmentalized. There are different units which take care of engineering, design, installation and other aspects of construction projects. Though these firms are small in num R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. ber, they contribute a disproportionate amount of the industry turnover and account for the industry profit. For example, in 1964, only 0.0005 percent of the firm accounted for 19.2 percent of the industry’ s output. In 1992, while firms with five or more employees were only 11 percent of all firms, they accounted for more than 80 percent of the total output. The profitability of most firms is pretty low. Only if a firm is able to cross a particular threshold size the returns are substantial. Firms tend to specializing in few aspects of the construction process. For instance firms may specialize in road building, residential complexes, stadi ums etc. The firm specialization is independent of firm size. Firms can be roughly divided into three categories: private residential, private commercial and public construction. Firms or projects may not always strictly fall into one of the above categories. The type of projects undertaken by the construc tion industry are mostly residential. In 1994 alone, about nearly one half of the general contracting labor force was employed on residential projects. Due to this dependence of the construction industry on housing market, the con struction industry is subject to unforeseen events and unpredictably. Just as the housing market is dictated by booms-busts, so too is the construction industry. The construction industry therefore is extremely sensitive to vari R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. ables liking interest rates and prices of industry inputs. On the demand side the factors which effect the industry most is demographic changes, move ments in economic cycle and immigration. Another factor which effects the industry is government expenditure. The government probably spends an equivalent amount of money on construction as the private sector on public housing, roads, dams and various projects. This sometimes provides a cush ion to the industry in case of slumps in the economy. Therefore we see that not only does the industry face low profit margins (due to its varied structure and low productivity) but also due to its sensitivity to the economy. 1.2.2 Institutions The construction industry and the construction market has well established institutions which over years have provided the industry with set of rules to operate. The institutional framework is mainly provided by a large number of contractor associations. The associations include a closely knit group of the nation’ s largest general contractors, and a loosely connected cohort of special trade contractors. These organizations in various ways seek to provide an environment for the contractors to function efficiently and to increase the common value of the whole industry. They are active in the political field, R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 6 labor negotiation, dissemination of trade information and dispute resolution. The associations are formally structured and have strict rules and member ship plans. Some associations are unionized traders since this enhances their power in the bargaining process. Apart from associations of contractors there are associations and groups of other professionals involved in the construction industry. This includes the architects, workers, mechanics and arbitrators. One of the main reasons for different groups having their own associations is to enhance their bargaining power during the bargaining process. For ex ample, the workers and mechanics who have unions help define work rule, job conditions, and description of employees’ responsibilities and benefits. Another service these associations provide is that they create standards in the industry. The main association for the general contractors is called Associated Gen eral Contractors. This association provides a number of services for the general contractors. Its main function is to provide information about the industry in America. The type of information it provides ranges from in formation about contractors and surety providers, to latest government reg ulations and new developments in governance mechanisms. It helps bring different players, contractors, owners, architects, and surety providers, in the R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. construction industry together. The AGC has standard contractual forms, which the players can use when they sign an agreement. These contracts help form standardized rules and norms in the industry. One of the main associations in the construction industry is the Amer ican Institute of Architects (ALA). This association, apart from providing service to the architects, provides some key services for the whole construc tion industry. Over the last few decades, the AIA has designed the basic contractual form which is used in the construction industry. The AIA, like the AGC, provides standard contracts for all the agreements which are made in the construction of a project. These contracts include agreements between the owner of the project and the general contractor, agreement between the general contractor and the sub contractor and the agreement between the architect and the owner. We will discuss the contract form which the AIA provide later in the chapter. 1.2.3 Players Owner The owner is the entity who employs the contractor to build the project. The owner decides what to build, provides the design, the organiza tional process and the money. Most owners are one shot players apart from R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. the real estate people. Owners who are inexperienced have little idea about how the construction industry operates. Inexperienced owners generally have a competitive bidding when they start a project since they have such little knowledge about construction to actually negotiate. Also owners who have little knowledge of how things work use standard construction contracts pro vided by AIA or AGC. Such owners are likely to make frequent changes and to be unclear which might lead to problems in interpretation. If such a prob lem arises then the court generally will favor the owner since the owner is not experienced. Contractor In the construction industry there are all kinds of big and small contractors. Most are small family run with five to ten employees. Contractors, especially the small ones, obtain the contracts through com petitive bidding. Profitability of these firms are very low and they often face bankruptcy. Two out of three contractors in the industry are speciality contractors. Therefore most contracting work is done under sub-contracts. In the following section we will discuss the relationship between the prime contractor and the sub contractor in greater detail. The prime contractor coordinates all the work. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. Sub-Contractor With high specialization in construction work, most of the tasks are sub contracted. In the hierarchial structure of the contract re lationship the prime contractor is between the owner and the subcontractor. The contractor is responsible for subcontractor’s work to the owner and he also has to take care of the sub contractor’ s liaison with the owner. When the contractor bids or negotiates with the owner on the main project he also invites bids from sub contractor or negotiates with them regarding the tasks he wants to sub contract. During the performance the contractor pays the subcontractor on the work done every month and closely supervises the work at the same time. There are often complaints during the project performance by the owner about the quality of work or by the subcontractor. If there are complaints against the sub-contractor by the owner or vice-versa, the con tractor has to take sides either with the owner or the subcontractor. He may side with owner and demand better performance from the sub contractor, but the contractor’s first instinct is generally to defend the subcontractor’s job, since a breach by the sub contractor also constitutes a breach by the con tractor. Also the contractor often has a long standing business and personal relationship with the sub contractor which he may not want to jeopardize. On the other hand, the owner as noted earlier is a one time participant. Since R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 10 the contract entails the completion of the project according to the drawings and specifications, a subcontractor’s defective performance places the con tractor in breach of the agreement. Therefore the contractor attempts to ensure, through monitoring, that the subcontractor performs according to the contract documents. See Nomellim Construction Co. v Harris (1969) 272 CA2d 352. The prime contractor brought suit against the sub contractor for failure to supply and install a fence. The relationship between the owner and the sub contractor is through the contractor. A sub contractor deals with the prime contractor and not the owner due to the lack of privity of contract, unless the owner signs a payment bond. If the privity of contract does exist between the subcontractor and the owner, the sub contractor can recover from the owner. See G&P Electric Co. v Dumont Construction Co. (1961) 194 CA2d 868. Most contracts, in order to save the owner from the sub contractors’ claims, maintain that there is no legal relationship between them. But this also limits the owners capacity to sue for breach against the sub contractor. Architect As we have seen in the preceding paragraphs the architect plays various roles in the projects from the designer to supervisor, from arbitrator R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 11 to subcontractor. In Huber, Hunt & Nichols, Inc. v Moore (1977) 67 CA3d 278 stated that “ an architect occupies three different roles or legal posi tions in relation to ordinary construction contract: 1) He is an independent contractor in preparation of initial plans and specifications. It is now well settled that in such a capacity the architect may be sued for negligence in the preparations of plans and specifications either by his client or by third persons; 2) he is an agent of the owner in supervising the construction work as it progresses; and 3) he is a quasi-judicial officer with certain immunity when he acts as arbiter in resolving disputes between owner and the contrac tor” . An engineer assumes liability for the plans he designs by signing his seal to them. However the engineer is not liable for parts of the design details which are missing if it is beyond his expertise. The engineer/ architect is not responsible for the performance of the contractor, though the architect often ends up playing the supervisor of the project in which case he is liable for performance errors. It is due to this added liability for errors during perfor mance that the architects have increasingly decreased their responsibilities as supervisors over the last decade. Apart from the architect’ s liability to the owner (Huber, Hunt & Nichols, Inc. v Moore (1977) 67 CA3d 278 and Chaplis v County of Monterey (1979) 97 Ca3d 249 ), the architect can also R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 12 be liable to the prime/general contractor. In CO AC, Inc .v Kennedy Eng’ rs (1977) the contractor claimed that the engineers failed to provide adequate information during the construction. Other Parties The surety provider is another important player. The surety provider provides a surety or a bond to the owner of the project that the contractor is going to complete the project. In case the contractor is unable to complete the project, the surety provider has to find another contractor who is going to complete the job without any extra cost to the owner. The other notable player is the lending institution. In most cases the owner of the projects borrows money from lending institutions in order to pay for the cost of construction. Therefore, not only the contractors are strapped for capital but also the owner has a binding budget constraint. This relationship between the lending institution and the owner is important because if the contractor does not get payments from the owner, then de pending on the relationship between the owner and the lender the contractor can take the lender to court as in S. C. Anderson Inc. v. Bank of America (1994) 30 CR2d 286. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 13 1.2.4 Construction P rocess The construction process starts with the design and contract, followed by the construction of the project, and finally, the completion or termination. In this chapter we will describe and discuss the whole process as we discuss the contracting and the execution of the contract by different parties. The process starts with the owner, who with his architect, draws the initial plan and design for the project. This may include a full complete drawing or just an initial approximate plan. After this a contractor is selected through a bidding process and with whom a contract is written. The contractor then starts the project and upon completion hands the project over to the owner after he gets paid. 1.2.5 Contracting The contracting itself starts with the attorney of the owner makes a pre contract survey after the design has been drawn. The attorney makes sure that the project satisfies all the requirements of the government agencies like the environmental and developing authorities. This includes land lease or acquisition requirements, hazardous waste requirements, and geological surveys. Apart from the government requirements, the owner generally has R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 14 to undertake feasibility studies, financial requirements, drainage and sewer requirements. After the requirements are met, a contractor is chosen. The owner looks at number of aspects of the contractor. The owner looks at the contractor’s financial responsibility, reputation, and experience. Information about the contractors can be obtained from various contractor’ s association including the AGC. The State Licensing Board also provides information about the contractors. After the owner has decided which contractors are suitable for the project the bidding process starts. Com petitive Bidding The process starts with an invitation for bids, with the invitation containing rules to bid. The invitation to bid may be given to all contractors or only to a select few. Most bids have time deadlines which are strictly followed. The owner also provides the prospective bidders with drawings and specifications. The owner has the discretion to accept or reject any offer. In private contracts it is not obligatory for the owner to accept the lowest bid. The owner can look at other variables like time of completion, familiarity with the project and method of working. The owner might undertake open or closed bidding. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 15 After the prime contractor gets the invitation, he looks at the drawings and details of the project. He in turn accepts bids from sub contractors and suppliers. After receiving the bids from the subcontractors the prime contractor estimates the cost of the project and makes the bid. As mentioned earlier, the owner generally reserves the right to accept or reject. Often between the prime contractor and the owner there are post bid negotiations. The contractor can approach the owner and can offer to work for less than the lowest bid. Similar behavior, i.e., pre and post bidding negotiations is also observed between prime contractors and sub contractors. A bid can be withdrawn after it has been made. This often happens, since the bidders realize mistakes in the drawings and specifications after they have bid. But if the mistake arises due to the bidder (contractor) then they cannot rescind the contract. Its generally the contractor’s obligation to discover the mistake in the plans. Also a subcontractor cannot withdraw a bid if the prime contractor has made his bid based on the subcontractor’ s. In private contracts often the bid which is accepted is not the lowest bid. The owner may look into other aspects of task involved like scheduling, reputation etc. Also there are often post-bid negotiations between the owner and the contractors. Some times specially if a project has to be started and finished within a short period then R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 16 the owner may just choose a contractor based on the reputation and sign a contract. Types of Contracts Construction contracts between the owner and con tractor are generally classified according to the nature and the size of the project, owner’s preferences which in turn depends on owner’ s sophistication in construction matters. The type of contracts can be classified according to a) Method of pricing the project, or b) Extent of drawings and specifications. Contracts described according to method of payment are 1) lump-sum con tracts 2) cost plus contracts and 3) cost plus with a guaranteed maximum. And contracts described according to extent of drawings are 1) complete specification 2) design-build and 3) fast track. Contracts classified by M ethod of Pricing: Fixed-price con tracts: A fixed price contract can be a lump-sum contract or a fixed unit price contract. A lump-sum contract is when the contractor agrees to complete the whole project described for a fixed price. In this case complete specifications are generally given. A fixed price per unit contract is when price for tasks are fixed per unit (e.g. so much per cubic yard for fill). So that the price per R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 17 unit is fixed but the total cost will depend on the amount of work. In the initial contract the unit of work will be the engineer’ s estimate. The contract sum is decided when the contract is decided. This contract sum is decided on the basis of the tasks agreed upon by the owner and the contractor. If there is any unit fixed price element included in the contract then they are generally also mentioned including the tasks. Contracts with only fixed price characteristics are hardly seen. Variant fixed price contracts that are observed are contracts which include a) target costs; b) target profits; c) ceiling price and d) sharing formula. Contracts with sharing formulas are contracts which specify the amount of cost the owner is liable if there are cost overruns. The owner generally makes progress payments every month. Generally the overseer of the project, the architect has to ratify the work which has been done in the past month before the owner makes the payment. And the final payment is made after the whole work is completed and the balance is payed to the contractor. Cost-plus contracts: In a cost plus contract the contractor is reimbursed generally every month all the cost plus an amount ( fee) to compensate for the overhead. The fee is usually 2 to 15 percent of the contract price. The advantage to the R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. owner of such a contract is that the owners pays only the actual costs but at the same time the contractors do not have a strong incentive to economize, especially since the fixed fee they get is a percentage of the cost. These type of contracts are generally used for unusual projects or novel projects that do not need a high degree of specificity in drawings. As will be discussed later often such projects are seen in “fast track” projects. These contracts are usually negotiated and do not result from the bidding process. With this contract the parties agree to the given drawings and specifications with a date of commencement and completion. Liquidated damages can be included. The contract sum, that is the amount to be paid to the contractor, is the cost of work mentioned in the contract. The type of costs which are to reimbursed are described which include labor, materials, subcontract costs etc. The contract also describes in detail the type of costs which are not to be reimbursed. Progress payments are made once every month or once every fortnight depending on the agreement. The contractor sends the bills and the vouchers of his job to the architect or the authority who oversees the project, and depending on the ratification, the contractor gets reimbursed. The architect, generally has the authority to ratify the cost of work and the pay the bill. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 19 Cost-plus contracts w ith guaranteed maximum price: In a guaranteed maximum price contract the owner reimburses the con tractor for costs, overhead and fees as in the cost plus contract but stops paying once the guaranteed maximum is reached. This gives the contractor to work within the limit. Another variant of this type of contract is where the contractor and the owner agrees upon a fixed price in case for “contin gency” , where the type of contingencies are described in detail. Disputes can arise whether the contractor can unilateral right to use the contingency funds. Like the cost-plus contracts discussed earlier the scope and cost of work is described as well as the type of costs the owner does not reimburse. The date of initiation and completion are mentioned. Default rules are men tioned. The contract sum is mentioned as the cost to be reimbursed and to be paid monthly and the guaranteed maximum is also specified. Contracts Classified by the Extent of Drawings and Specifica tions. Com plete Drawings and Specifications Furnished by Owner: The most commonly used contract is single prime contract under which the owner furnishes complete drawings and specification. The contractor has full construction responsibility but the project is supervised by the architect R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 20 or the engineer. In most of these jobs the prime contractor subcontracts almost everything while himself only manages the whole project. Design Build C ontracts: Under these type of contracts the contractor is responsible for the de sign. The traditional projects used are process facilities, parking garages and metal buildings. The owner specifies the desired performance parame ters and the contractor uses standard components and details to reach the desired outcome. The contract takes the design responsibility while the pa rameters given to him might be heating, ventilations, and air-conditioning, plumbing etc. The design build contracts are relatively new phenomenon. As the contractor takes the responsibility of design. This form of contracts have evolved as a result of the architect/engineer’ s desire to avoid liabilities. Interestingly the contractual job description in some form of contracts have changed from “supervision of work” to “inspection of work” and presently to “observation of construction” . In the design build contracts the contractor employs subcontractors to employ to design and draw. The advantage of this is that the combined knowledge of contractor and subcontractor is superior to that of architects in current trade practices. The owner also expects to benefit from better participation from the subcontractors, because they can R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. perform in their preferred manner. And problems of interpretation can be worked out in the field itself between the contractor and the subcontractor, also the contractor has the power to enforce discipline among subcontractors. One of the main advantages as mentioned earlier is that this kind of contracts help to reduce the likelihood of disputes. Since the contractor is responsi ble for the errors and omissions, the owner can insist that the project be completed in time and within the contract price. The disadvantage of writ ing these kind of contracts is that the contractor and the subcontractor can cheapen the project, that is they can reduce the quality of the project. Also such contracts can be written only for standard projects otherwise disputes are likely to arise over both the scope of work and its quality. Fast-T rack C ontracts: Fast-track contracts are used when the project needs to be completed in a hurry due to high interest rates or limits on land use entitlements. In fast-track contracts the contract is signed before entire project is completely described or designs and specifications are completed by the architect. The contractor and the subcontractor bid on incomplete plans. The architect completes the specifications after the contract has been signed. The con tract price in such a contract will include performing work, and supplying R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 22 equipments and materials that are reasonably inferable according to com mon trade practices. The architect supervises the project and all addition to contract documents and changes can be made only after the architect has given written sanction. Due to the incomplete plans when the project starts, these contracts tend to be those most frequently disputed. Rights and D uties The doctrine of conditions protects the actual ex change of performance specified in the contract. This doctrine basically states that a contracting party does not have to perform its promise without obtaining the other party’s promised performance. In the construction industry, the “work first and then be paid” is generally not followed. This is because the contractor must finance the cost of the performance. K the contractors were forced to perform first and then get paid, they would be open to the risk of the owner breaching or deviating from the contract. In order to protect the contractor from owner’s breach and at the same time follow the doctrine of conditions, the method of payments followed is progress payments. The owner makes periodic monthly payments to the con tractor depending on the amount of work completed. If a cost plus contract R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 23 has been written, then the contractor submits an application for payment a few days before the payment is scheduled. The application is the documen tation in support of the costs incurred in the last period of the construction project. The documentation is generally consists of the bills for labor and equipment. In case of a fixed price contract, the contractor provides evidence that a portion of the complete project has been finished. So if the contrac tor finishes a fifth of the total project during the last period, he is paid a fifth of the total price. The application for the payment is ratified by the architect, who is the owner’s agent in the project. The state and the law tries to protect the contractor from non payment. Such protection increases the efficiency of the process (Federal Prompt Payment Statutes 31 U.S.C.A. *3901). The contractor, who is capital constrained, if not paid in time, will either stop working or breach. The procedure is that seven days after the payment was due, the contractor serves a seven day notice of intention to suspend work. After the seven days the contractor can suspend work. The suspended work is not viewed as termination. The court prefers to give more time and look into the cause of delay before announcing that there has been material breach resulting in termination. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 24 T erm ination an d C om pletion Some contracts have the provision that the contractor is paid in full after substantial completion of the project. Sub stantial completion may be defined in the contract as a series of tasks the contractor should finish. The process for determining substantial completion is that the architect inspects the project to see if a list of items has been finished. If it is agreed that the project is substantially complete the owner takes possession of the project after making the final payment to the con tractor. In case of substantial completion the main issue is agreeing to what is substantial completion, if it has not been defined clearly before (Plante v. Jacobs, 10 Wis.2d 567 (I960)). In most cases the owner takes possession of the project after full com pletion of the project. According to AIA directed process, the contractor notifies the architect and the owner that the project is over and is ready for final inspection and acceptance and the contractor makes an application for final payment. The architect makes the inspection as an agent of the owner. Possession of the project by the owner involves changes in ownership of land, new allocation of risk, such as risk of defects, and continued existence of claims. The contractor often has pending claims on the project even after the project has been handed over. If the claim has not been made in time R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 25 then the contractor can lose the payment he thinks he is due (see Mingus Contractors, Inc. v. United States, 812 F2d 1387 (1987)). The main risk the owner faces when he takes possession of the project is that the product he receives might be defective. In most cases he is protected from defective construction. In case of defection due to poor performance by the contractor, the contractor is liable to rectify the defects without extra costs or to pay the damage. 1.2.6 Changes C hange O rder M echanism When a contract is drawn, the architect preparing the drawings and the specifications of the construction project at tempts to anticipate and specify every item of work, equipment and material to be incorporated. Yet changes have to be made in virtually every project. Changes are made due to extra work, errors in drawing or simply because the owner wants to add or change extra features. Primarily the changes have to be made due to the fact that the people drawing the contract are unable to predict every contingency. In construction contracts, procedure for changes to be made to the con tract are well specified ex ante. Most construction contracts used are drawn R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. by the American Institute of Architects (AIA) and Association of General Contractors (AGC). All these contracts have extensive description of how the contract should be changed during the performance of the contract. The contract is going to be renegotiated if the contractor is unsatisfied with the compensation he is getting for his job and the owner would like to make changes if she wants to make some change in the design of the project. Two instruments are used to renegotiate a contract, the Change Directive and the Change Order (CO). For instance if the owner wants to make some changes in the design which involves substantial change in time e and sum, then along with her architect she draws up a document called Change Direc tive (CD). This CD describes the exchange in the scope of the contract along with the change in pricing. The pricing can be done in the following ways: 1) mutually accepted lump sum compensation (accompanied by sufficient data of changes in design by the owner and the costs incurred by the contractor), 2) unit price already being used in the existing contract, 3) cost of the change which will be mutually agreed on. If this CD is accepted by the contractor ( the other party) and it has been signed by the owner, contractor and the architect the CD becomes a CO. The CO is a mutually accepted change in work, change in contract sum and change in contract time. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 27 Assuming that it is the owner who initiates the most number of change in the existing contract due to a preference shock, the procedure of renegotiation as specified by the contract is the following: • Owner asks for change and lets the architect knows about it. She has to provide with her request a detailed design ( which she draws with the help of her architect), the change in time and price specifications. • The architect asks the contractor to make the changes in the contract according to the change directive. • The contractor after he gets the CD is supposed to start work on it immediately. If he does not it is considered breach. • If the contractor does not agree with the time and sum(price) change in the CD then he is supposed to get back to the architect with price quotation and a detailed list of the cost he has incurred or is likely to incur within twenty on days. • If the parties cannot agree on the price and time of the change then the contractor gets the cost and overhead of the work according to the cost description he has provided. But the compensation for cost is R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 28 limited to 1) labor, 2) materials, 3) rental costs, 4) bond payments and insurance, and 5) cost of supervision. • If the CD is not in dispute then the contractor places the application of payment and the CO with the architect indicating he in whole or in part agrees. If he disagrees then the architect arbitrates over the amount. If both parties are able to agree on the amount and time then the CO is implemented. • Both parties have the right to disagree with the time and amount and go to court. The contractor can also ask for the change in contract details if he is not satisfied with the contract in the given state. In most states it is advisable for the contractor to continue with work, even though he might ask for changes in the contract. If the contractor feels that the states reached are due to the fault of the owner or due to some action of the owner then the contractor can stop work and ask for changes in contract terms. The contractor can also claim impossibility doctrine to stop work or cask for change in clauses, that is, if the state reached is such that is not economically feasible for the contractor to finish the task. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 29 Types of Changes The change orders can be classified into the following types: Cardinal Cardinal change was defined by federal legislation in order to limit the type of change the owner can ask the contractor. If the change is drastic enough to alter the nature of the task then the change is cardinal. The contractor can agree to the change or disagree. If the owner refuses to proceed with the project unless the contractor agrees with the changes then the contractor can take the owner to court claiming breach. The contractor has the option to take the owner to court either in the middle of the project or after the completion. Constructive Often the owner or the architect proposes changes to the initial design and the project which are not substantially different from the initial project. In such a case the change is constructive. Such changes are supposed to be under the original contract. Determining what is a con structive change is important since the contractor is supposed to perform the change asked under the initial price. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 30 D eductive Change clauses permit the owner to delete portions of the work from the project. This raises problems since deleted work might reduce overhead and profit. 1.3 Ingredients For D isputes 1.3.1 Expectation and Disappointm ents Each party in the contract enters the into the agreement with some ex pectations of benefits and returns. The owner expects to get a project as specified in the contract and the contractor expects to get the payment for the construction. The owners initial preference or expectation may change later during the construction and he may adjust the contract with help of change orders. The expectations of both the parties reasonably difficult to measure when the contract is signed. The performance of the contractor generally depends on various factors including cooperation of all entities in volved, weather, and soil conditions. And when these expectations are not realized, the contractor does not get paid in time or the owner does not get the product he wants and disputes arise. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 31 1.4 D ispute R esolution 1.4.1 Arbitration Most contracts have arbitration clauses. The contracting parties choose to have the arbitration clause because dispute resolution under arbitration is much quicker and less expensive. The cost of arbitration is generally a fixed fee which ranges from $200 to $1800 and percentage of the claim or the counter claim, ranging from 3 percent to 0.25 percent. If any case is dis puted then it is mandatory that the dispute should go to the arbitrator, the parties can also waive arbitration but only they have litigated some of the arbitrable issues. The arbitrator is often decided in the contract it self or can be decided later before the dispute. The arbitrator is generally chosen from the American Arbitration Association, and the number of arbitrators assigned depends on the size of the dispute or the amount claimed. Arbitrat ing can also be done by an agent selected by one of the parties themselves. For instant the owner might decide that the architect is going to arbitrate if any dispute arises. There are number of clauses under which the affected parties can ask the court to review the judgement of the arbitrator. If the assigned arbitrator belongs to one of the interested parties then the court R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 32 generally overlooks the judgement of the arbitrator. Another rule which af fects the dispute stage in the contract relationship is that if the disputing parties have not gone to trial within five years of first fifing the case then the case will be dismissed. The court gives enough time to the disputing parties to try and come to an agreement with an arbitrator. 1.5 Law and Economics of Contracts Since the nineteenth century in common law scholars have developed and followed what is commonly referred to as the bargain theory of contracts( Eisenberg (1982), Craswell (2000), Rakoff (2002)). The contract is viewed as a promise as a result of bargaining by the contracting parties (Katz, 1990). The duty of the law is to uphold the promise made during the bargaining. Bargaining is the necessary and the sufficient condition for the existence of the contract (Posner, 1977). In legal terms three stages are viewed as the bargaining process: the offer, the acceptance and the consideration. The bargaining theory considers a contract complete when one of the contract ing parties makes a promise to perform a service or to provide a good in the future, and the other party agrees to make a reciprocal payment for the promise to perform. Bargaining theory also considers what happens if either R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 33 one of the participating parties do not perform as promised. According to this theory the breaching party, the promisor, should pay the other party, promisee, the damage amount which will make the promisee indifferent be tween performance by the promisor and the damage amount. This damage measure is the expectation damages. The main critique of the above the ory of contracting is as long as the promise has been made to perform, the promisor has to perform the contract. 1.5.1 The A gency Relationship Often contractual relationships between two parties are recognized as agency relationships. In a typical agency relationship, there is a principal and there is an agent. Generally a contract exists between the principal and the agent such that the agent has to perform a service or provide a good to the prin cipal in return of some reciprocal inducement, often some kind of payment, from the principal. Though the relationship between the principal and the agent is governed by the contract written between them, there are potential problems in the relationship regarding the rights and duties of the principal and the agent. Over the last couple of decades economic theorists have pro vided various theories about the type of contracts which should be written R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 34 in different environments. Economists have discussed and analyzed both so cially optimal contracts and contracts which are optimal from the individual participating party’ s point of view. Legal scholars have focussed on the role that the law can play in the agency relationship (Goetz and Scott, 1985). The law has dealt the problem with the help of contract law and agency law. The focus of the law has been on designing rules to reduce inefficiencies due to disputes by defining the rights and duties of the principal and the agents. Understanding the agency relationship is essential to understanding the different forms by which persons conduct their business affairs. In an agency, a person or an agent works for the principal and takes action for the principal. The agent, who may be an outside contractor or an employee is supposed to take his action in accordance with the preference of the principal and be a representative of the principal. The problem in the agency relationship is that the agent may choose not to act according to the demands of the principal. Due to such possible behavior of this the principal often has a more direct control of the agent. But such control can be counter productive as the control of the agent may decrease the incentive of the agent to perform. We will discuss these issues of authority and incentives in greater detail later. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. The importance of agency is emphasized by the fact that the agent often undertakes a transaction with third parties on behalf of the principal. Thus, if the agent acts on behalf of the principal in any transaction with a third party, the agent’ s actions binds the third party with the principal. This may often result in disputes between the third party and the principal. For example if an owner of a project contracts with the design professional to design and oversee the work of the contractor in a construction project, the contractor may sue the owner if the contractor is unsatisfied with the design professional. The design professional in this case is the agent of the owner who performs on behalf of the owner through out the entire transaction. Commercial Efficiency and R easonable E xpectation The agency re lationship has developed as a commercial necessity wherein a principal em ploys an agent to perform certain services for him. The problem arises as the agent exposes the principal to certain risks. Since it is not possible for the principal to perfectly monitor the agent, the principal is subject to the action of the agent. The agent may choose to act for his own benefit instead of that of the principal. The compensation the agent receives for provid ing the service to the principal has to be designed so that the agent puts R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 36 in optimal effort or optimal care in the service. The problem is that such a compensation scheme or reciprocal inducement for the agent may be difficult, or impossible, to write. In such case the law plays an important role. The law protects the principal from unauthorized commitments or actions of the agent. At the same time the law also safe guards the rights of the agents so that agents are not exploited by the principal. The law provides solution for these problems in the agency relationship in accord with the concepts of social efficiency and common sense. Principal and Agent The relationship between the principal and the agent is created once the contract is formed. The agent may be an employee of the principal or may be an independent person hired for a particular task. Principal agent relationship is different from arm’s length commercial rela tionships. In an arm’ s length transaction no general obligation is imposed on one party in order to protect the other. The parties have to protect them selves. The parties need not disclose facts about the trade to each other . The relationship between the principal and the agent is fiduciary, that is based on trust and faith. The law provides the protection to the parties if promises, both explicit and implied, are not kept. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 37 1.5.2 Legal D octrines in the Construction Industry In the description of the construction industry one of the things which stands out is the importance of the norms and the rules used in the construction industry and the legal doctrines used by the court in this industry. Over whelmingly almost all legal doctrines which govern this industry are derived principles of economic efficiency. The court when choosing to intervene in the transaction, either in the gap filling role or to provide protection to one of the parties in the trade, does so primarily to increase the total surplus of the trade (Ayres and Gertner, 1989). The courts choice of the damage rules clearly indicates this. The court, however, does use doctrines, like uncon- scionability (Kurland v United Pacific Insurance Co. (1967), 251 CalApp2d 112), in order to protect weaker participant in the trade (Epstein, 1975). In the section below, we discuss some of the doctrines to substantiate this claim. A u th o rity In agency relationships the agents are supposed to be acting on the principal’ s behalf. Though the agent acts for the principal often the interesting question is who has the final authority of take the decisions during the performance of the given task. The principal may choose to give the agent complete authority to choose his actions or he may choose to withhold the R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. final say in any action taken by the agent. The problem with the issue of authority is not only due to the allocation of authority but often also due to the informal nature of authority. In certain contracts authority is implied and not written. The problem arises due to the diverging goals of the principal and the agent. The agent chooses an action to maximize his benefit, which often is not the same as that of the principal. For example, in case of the management and the shareholders, the management will choose its actions in order to increase its salary and not the share prices. Though the court realizes and enforces the rule that the actions by the agent are taken in order to benefit the principal, the court also recognizes that the requirement of the agent to have some discretion over his actions (see Frank Sullivan Go. v. Midwest Sheet Metal Works. 335 F2d 33 (1964))- The reason is that some authority provides the agent with better incentives. 1.5.3 Contract Formation As discussed earlier in the chapter the principal function of writing contracts is to enable an efficient economic transaction between two self interested parties. This is done basically by providing each contracting party with a reasonable expectation that the respective parties will fulfill their contractual R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 39 obligation. The law enforces each party to fulfill its obligation. An important aspect of the contract formation is that the participants in the contractual agreement have the freedom to design their own economic exchanges. The participants are free to choose the trading partners with whom they want to trade and the terms of trade. To the players in forming contracts this freedom is essential since this ensures cooperation and performance in the transaction of all among participants. Also the autonomy of the participants ensures that the best possible contract or deal is written since the participants have the best information about the transaction. Though the participants have complete freedom to write any contract they want the law ensures that the contracting parties have relatively equal bargaining power, equal accessibility to information and a relatively free market place. If these conditions are not met then the state and the federal courts have the power to intervene, interpret contracts and determine the validity of the contracts. M utual Assent For a contract to exist there has to be offer and accep tance. Each party has to believe that there is a contract in place. The con tract binds the parties by what each party, explicitly and implicitly,manifests to the other party. This way the law makes sure that the reasonable expec R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 40 tations of the parties are protected from the hidden intentions of the other participant. The process by which an agreement or a contract is made is through communication, written or oral. This mechanism basically includes an offer by one party and an acceptance by the other. An important aspect of the deal to be recognized by law is that the person making the deal has to be a reasonable person, a valid representative of the contracting party, who in the future can make relevant decisions. The doctrine of mutual assent assumes that the contracting parties have agreed to perform their duties and are reasonably certain of the promise made by the other party. Therefore the definition of reasonably certain becomes important. Reasonably certain does not mean that the contract terms have to be so clear that there is no doubt about their meaning. The court often gives some leeway to the contracting parties in use of the terminology in writing contracts and allows to use' terms such as “ substantially”, “about” and “nearly so” (see Janzen v. Phillips, 73 Wash.2d 174 (1968)). Generally for the contract to be acceptable, the offer and the acceptance or revocations have to be written. But the court also accepts oral contracts (Asdourian v. Araj, 38 C3d 276 (1985)). Oral contracts often arise if it is R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 41 expensive to write down the agreement reached. Oral contracts are enforce able if it can be shown that there was an agreement to agree and there was an agreement to deal in good faith. Mutual assent is subject to some defects. As noted earlier, mutual assent is a process subject to both parties’ correct representation of their intent and promises. Parties may not only deliberately misrepresent themselves, but may also may be negligent in their disclosure. The court protects the innocent party from both fraudulent and negligent behavior; while in case of the former, the innocent party may be awarded damages, the later generally results in cancellation of the contract. A contract can also be made invalid if it can be shown that one of the parties agreed to the contract in a state of economic duress or compulsion (Centric Corp v. Morrison-Knudsen Co. 731 P2d 411 (1986)). Courts also strike down contracts which they find to be unconscionable. This doctrine has mainly been used in sales contracts. The doctrine used most often to attack formation of the contract under mutual assent is mistake. Mistakes by one or both of the parties due to carelessness in contract writing is generally not acceptable by the courts. In order to use mistake to get out of a contract, the party wanting to get out R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 42 of the agreement has to show that its understanding of the agreement was drastically different from the contract. The court generally looks into the negligence in drawing the agreement, assumption of risks and the disparity of exchange in the transaction. 1.5.4 M aterial Breach Contractual disputes can arise if one of the contracting parties breach the contract. If either of the contracting party fails to act in accordance with the contractual clauses then the contracting party breaches the contract. Breach therefore includes non payment of fees by the owner or failure to perform by the contractor. If there is no dispute or ambiguity regarding the language of the contract or the interpretation of the contract then the main reasons for material breaches of a construction contract is when the contract is changed to include extra work, when the owner fails to make payments in time and if the contractor fails to perform according to the contract. Extra work is work that the contract does not specify. If the extra work asked by the owner is not within the scope of the work described in the original contract and the contractor is not reasonably compensated for the work then the owner breaches the contract, defining the scope of the work R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 43 is difficult and often leads to dispute since the scope of work depends largely on interpretation. Extra work is a common occurrence in most construction contracts. Due to the complexity of the projects, it is expensive to provide drawings and specifications and to anticipate for every item of work , equipment, and material. Also mistakes are often made, which are realized only after the project has been started. Therefore extra work and new features are added to the contract and the project almost in every case. But the problem of breach arises because if the work which is within the scope of the original contract then the contractor is not given any extra compensation. If the work is outside the original contract then there should be some compensation for the contractor. Due to the nature of the extra work, if the owner dominates the relationship or has all the bargaining power in the relationship then the owner can ask the contractor to do the extra work without any extra compensation. But if the contractor has the informational advantage in the project then the contractor can extract higher compensation from the owner by forcing the owner to renegotiate the contract during the construction process. According to the construction industry rules and norms in almost contracts the by default the contractor has an obligation to perform the extra R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 44 work requested by the owner. The reason is that the contractor has the informational advantage over the owner and therefore to protect the owner, the owner is given the option in the renegotiation stage. Therefore in most contracts, AIA, and AGC contracts and documents, the owner reserves the right to ask for changes if the changes are reasonable and not excessive. If the change asked by the owner is excessive then the contractor can contend that there is material breach by the owner and if there is no adequate change in the compensation schedule may stop work. Excessive extras changes the scope of the work in a major way. This means that the owner has changed the original contract. In case the original contract is changed the value of the work is not measured by the contract price. There are two reasons for this not only the contract has been changed but also since changes are complex the contractor may not be able to keep accurate record of all the changes (Daugherty Co. v Kimberly Clark Corp. (1971) 14 CA 3d 151). In Saddler v U.S. 287 F2d 411, the work was increased from constructing and filling a levee of 5500 cubic yards to 13000 cubic yards. This change, the court ruled was excessive and a breach. Similarly when the prime contractor insisted that the subcontractor backfill in three rather than in two phases there by increasing the cost by a million dollars the court ruled, in Peter Kiewwit Sons ’ R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 45 Co. v Summit Constr. Co. (1969) 4-22 F2d 242, that the prime contractor had breached the contract. The owner can also breach the contract if the owner does not make the payments on time. The payment method generally used is progress payments. In 1991 the legislature enacted some prompt payment statutes that oblige the owners to make the progress payments in time (see $2,139: California Mechanics’ Liens and Related Construction remedies, chap 4). If the owner fails to make payments for an extended period of time or out right refuses to pay then there is material breach. In Integrated Inc. v Alex Fergusson Electrical Contmctor (1967) 250 CA2d 287 the trial court decided that the owner breached when the owner failed to make the progress payments on time. Also see Porter v Arrowhead Reservoir Co. (1893) 100 C 500. If the owner breaches contract then the contractor can stop work. In case there is material breach by one party, the other can treat the contract as over (McConell v Corona City Water Co. (1906) 149 C 60). However the owner can with hold payment and not breach the contract if the contractor fails to perform according to the contract. In Smith v Empire Sanitary Dist. (1954) 127 CA2d 63, the contractor with held payment for labor and when the contractor failed to provide the product specified in the contract. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. In case the contractor fails to perform as required in the contract it is material breach. The contractor as mentioned earlier in the construction in dustry is required to perform and continue with work even if the owner asks for changes in the original contract. As mentioned earlier in most contracts in the construction industry the owners have the option to ask for changes if it is not unreasonable. But if the owner has breached the contract by asking for excessive changes then the contractor is excused of the performance. In Coleman Engineering Co. v North American Aviation Inc., the owner had the authority to make changes if the changes resulted in an equitable and mutually agreed upon price. The owner agreed to pay $40,000, while the contractor asked for $800,000. The contractor stopped performance but the court excused the contractor since the owner had breached the contract by demanding substantial changes. There are other excuses also for the con tractor like impossibility which we will discuss later. 1.5.5 Liquidated Dam ages Most damages used in case of disputes are actual damages realized during or after the project is finished. For instance the plaintiff gets the expected damages, reliance or the restitution damages. In case the contractor finishes R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 47 the project after the deadline then the owner gets the value lost due to the delay. Lately liquidated damages are being used in case of delays or if the contractor is unable to provide the specified product in time. Liquidated damages are damages of specific which the contracting parties agree on if there is unexcused delay. The reason given earlier by courts for not using liquidated damages is that it is difficult to ascertain delay damages (Goetz and Scott, 1977 and also see Midler v Light (1976) 538 S. W.2d 487). In Sides Constr. Co. v City of Scott City, (1979) 581 S. W.2d 443 the court stated “ there was a time when the courts were quite strong in their view that almost every contract clause containing a liquidated damage was, in fact, a forfeiture provision which equity abhorred, and therefore, nothing but actual sustained damages by the aggrieved party could be recovered in case of contract breach caused by delay past the proposed date of completion date. But in modern times, the courts have become more tolerant of such provisions. ..courts have become more strongly inclined to allow parties to make their own contracts and to carry out their own intentions, free of judicial interventions.” Liquidated damage are often used to be used for penal purposes and are much larger than the actual realized damages. Generally common law finds liquidated damages unequitable. The party with the higher bargaining power R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 48 can impose damages in the contract which are unjust. Liquidated damages, therefore are considered unconscionable. For this reason courts, as pointed out by the earlier quote, avoided using liquidated damages. One of the most important rules used for implementation of liquidated damages is the reasonable rule (UCC £2 — 718). The court allows the use of liquidated damages only if the amount of liquidated damages is reason able as judged by the circumstances existing at the time of the contract (see Dahlstorm Corp. v State Highway Commision of State of Mississippi (1979) 590 F2d 614, and Pembroke v Gulf Oil Corp. (1971) 454 F2d 606). Modern courts, however often let the parties use liquidated damages in case of dis putes due to delays and are more cordial towards liquidated damages. The court is willing to be relieved of the charge of measuring damages, not only since it is a costlier exercise for the court but also the court may not be able to value the damages correctly. This is pointed in the court ruling of Sides Constr. Co. v City of Scott City, (1979) 581 S. W. 2d 443- Also in Bethlehem Steel Corp v Chicago (1965) 350 F2d 649 the court ruled about the liquidated damages that “there is no reason why persons competent and free to contract may not agree upon this subject as fully as upon any other, or why their agreement when fairly and understanding^ entered into with a R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 49 view to just compensation for the anticipated loss, should not be enforced”. The main reason for the courts acceptance of the liquidated damages in the Bethlehem case is the courts believes that stipulated damages are a result of bargaining. Therefore as long as bargaining and mutual acceptance is there in designing the liquidated damages the court will accept the liquidated dam ages, given they are reasonable. In Rohlin Construction Co. Inc. v City of Hinton (1991) 476 N. W.2d 78 the Supreme Court of Iowa disregarded the liquidated damages and expressed concern with the arbitrary way the liq uidated damage amount was selected. The court ruled that there was no arm’ s length bargaining between the two parties at the time the damages were stipulated in the contract. 1.5.6 Rem edies for Contract Breach When courts generally intervene in contract breaches it is either to enforce the agreement or to fill in the gaps in the initially written contracts. If a situation is reached when either of the contracting parties refuse to carry on their part of the promise because they do not find it viable, the court can intervene. The court decides on a remedy which the breaching party must pay to the other party. Common law has developed conventional formulas for awarding R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 50 damages which follow the basic principal of compensating the parties. All the formulas to determine the damages for breach use the efficiency principal. In addition to the trade value maximizing principal, the relative abilities of the plaintiff and the defendant to bear losses and the reason for the breach influence the calculation of remedies. Damages: E xpectation, R eliance and R estitu tio n Damages are a protection, provided by the court, from possible breach by the other party. The three main remedies followed are restitution, reliance and expectation. Restitution is the most protected of all the three. Restitution is calcu lated so that it restores the status quo that existed before the contract was made. The plaintiff is awarded any benefit the plaintiff has conferred on the defendant. It is most protected since it is easy to establish and easy to measure. Reliance interest is when the plaintiff is paid or reimbursed all the ex penses from the defendant that have been incurred either in reliance upon the contract or expenses incurred before the contract was made which have become valueless because of breach. Though this often looks similar to resti tution the difference between the two is that reliance looks also at the future R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 51 returns from the deal. If the defendant or the breaching party can show that the plaintiff would never have recovered the reliance amount even if the contract had been executed, then the defendant can avoid paying the damage. The third protected interest is expectation. This is completely forward looking and is dependent on the future value of the deal. Expectation damage is when the plaintiff is awarded the value which the plaintiff would have received if the defendant had performed the contract. There are two ways which this can be awarded: either the defendant is asked to carry out the contract or asked to pay the expected return for the plaintiff. We will discuss this issue about the measure of expectation damages in greater detail later. Breach claims are made by the owner when there exists unexcused con tractual delay and or a failure by the contractor to build the project as required. Claims by the contractor are due to compensation for cost which are attributable to the owner. The standard form of claims are restitution, reliance, expectation and liquidated damages. Liquidated damages are gener ally not used in construction industry. The reason is that liquidated damages might be used unconscionably by parties with bargaining power (Bethlehem Steel Corp v Chicago (1950) 350 F2d 649). R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 52 Claims made by the contractor are limited. This is because the owner is generally protected by the contract which specifies that the contractor cannot make any claims. But these claims may not be completely enforceable and the contractor can get actual damages if the contractor can show harm by the owner’ s interference (see Peter Keimet Sons Co. v Iowa Southern Utilities Co. 355 ISupp376, 1978). Some states like New York, are conflicted about enforcing the “no damage clause” by the contractor. For instance, whlie the court enforced the “no damage clause” in Kalis ch Jarcho Inc. v City of New York (1983), the court overruled the no damage clause in Corinno Co. Givetta Construction v City of New York (1986). Generally the contractor can make claims if the following are true; a) unreasonable delay caused by the owner b) changes which are not contemplated and breach of fundamental contract. The standard contractual form provided by the AIA allows the contractor to make claims (AIA Document A 201 #8.2.3). The claims made by the contractor are made during three stages of performance, never started, partially complete and complete. 1) Project never commenced: Projects often get abandoned before they are started. The contractor in such cases generally asks for expectation damages or lost profits. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 53 2) Project partially completed: This is when most claims are made. Ex pectation damages are gain are the most common daim made. The three formulas which are used to calculate the expectation damages are a) the con tract price, i.e., the cost of completion (Tull v Gunderson Inc. (1985) 709 P2d 940), b) expenditure in past performance and expected profits (Restatement (second) of contracts tj3AlComment D, 1981), c) entitles the contractor to such a proportion of contract price as cost of work done bears on the entire cost of completing performance and for the remaining portion of the work the profit to be made (see Kehoe v Borough of Rutherford 56 NJL 23 (1893)). Expectation damages have to pass the test of certainty. Restitution is also available for partially completed projects. The contractor claims restitution in case of failure of the owner to make progress payments, excessive changes and failure to let the contractor work expeditiously. Restitution unlike both expectation and reliance can be objectively measured. The typical measures used to calculate restitution are a) cost of work performed and b) other bids made by other contractors for similar work performed. The contractor generally prefers to use the cost of work (United States v Alegron Blair Inc.). 3) Project is complete: Restitution cannot be claimed if the project is already complete (Kass v Todd). The contractor can only recover unpaid R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 54 balance and losses. Value of past performance is difficult to determine. Gen erally the contractor claims reliance, the actions of the owner which resulted in extra costs. Similarly the claims made by the owner depends on whether or not the project has been started, is partially complete, and or is already completed. As mentioned earlier the owner claims damages due to delay by the contractor or defective project. In case of delay the standard measure is expectation, the rental value (see Ryan v Thurmond 481 SW2d 199). Reliance can also be claimed but reliance has to be less than expectation. 1) Project never commenced: The owner typically claims lost rent (ex pectation damages) or reliance. 2) Project partially completed: Restitution is measured as progress pay ments already made. But restitution is difficult to get as it is difficult to measure the value conferred on contractor ( Village of Wells v Layne Min nesota Co. (1953) 240 Minnl32). Instead expectation is more protected, i.e., easier to get. Expectation damages are the cost of completing the job. 3) Project Complete: The most common reason for damage claims at the end of project completion is defective performance. The common measures are a) cost of correction and 2) value (defective ) - value (good), which is R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 55 the expectation damage measure. Most states, including California, prefer cost of correction measure unless the measure generates an inefficiency, cost is higher than the value (Granite Construction Co. v United States 962 F2d 998). Limits on Recovery In order to take into account the state or the cir cumstance in which the breach occurred, the law has put some limits on the recovery of damages from the breaching party. The first thing the damage claimant has to show is that the defendant is responsible for the loss of profits or returns for the claimant. This rule is called causation. For example, in the construction industry if there is a delay in the project and the claimant loses money because of it, he has to show that the delay was due to the lack of effort by the contractor. The next limit on the recovery is called certainty. The plaintiff must show that the extent of losses with reasonable certainty. Generally this means that the plaintiff should be able to provide proof of actual or estimated losses. Foreseeability doctrine and avoidable consequences also work as a check on the amount the plaintiff can recover from the breaching party. Since these two doctrines are generally used in all contractual relationships, we R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 56 discuss some defence claims here which are more common to the construction industry. Defence to Claim s Certain states may arise, where one of the con tracting parties refuses to perform as promised in the contract. In order to get out of its contract obligation the breaching party has to show that the realized state has seriously disrupted performance planning or performance itself. And if the breaching party can show that the realized state occurred in spite of its actions then breaching party can walk away from the contract without paying damages. C o n tractu al R isk A ssum ption When a contract is written, the contracting parties realize the possibility of certain states may arise. Therefore in case of a fixed price contract the contractor cannot claim additional compensation if he has to do extra work. M u tu al M istake If the breaching can prove to the court that the realized state is drastically different from what was expected when the contract started then breaching party has a defence for non performance (see Gevyn Construction Corp. v. United States 357 F.Supp 18 (1972)). For instance if the sub soil conditions, R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 57 encountered during construction turn out, to be very different from what has been described in the contract then contractor can claim mutual mistake in the formation of the contract. Im practicability A contracting party can get relief from performance if it can show com mercial impracticability ( Taylor v. Cadwell 122 Eng.Rep. 309). The breach ing party to get relief has to show that an unexpected event occurred and the risk of this unexpected event had not been allocated to the breaching party. The other important restriction from using this defence is that the breaching party has to show that a similarly placed contracting party would also find it impractical to perform. Frustration Frustration of purpose is when the performance is not desirable due to the realized state (Krell v. Henry 2.K.B. 740 (1903)). Therefore this doctrine does not look at the effect of the realized event on performance. This doctrine can be used owner if the owner decides not to go through with contract if a certain state arises in which the value of the project is almost zero. The court use this doctrine sparingly since this would put the contractor at risk and make contracting quite ineffective (Lloyd v. Murphy 25 Cal2d 48 (1944))- R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 58 Other defences can be based on timing of the claim. If a claim is made considerable after the end of the project then the defendant can use the timing of the claim as a defence. For instance if the owner brings a suit for a defective product then contractor can claim acceptance by the owner after considerable time has elapsed. 1.6 Conclusion This chapter primarily provides a description of the construction industry and legal rules used in case of disputes. In most cases, the contractual relationship between all the participating parties, including the contract formation and the rules governing the renegotiation of the contracts, can be explained by the efficiency rules. Contract formation in the industry can be explained by the theory of bargaining. Theory of bargaining between the agents also explains the rules in the industry like the change order rules which govern the construction process. Damages which are used in the industry can be explained by the principals of social welfare maximization. The other legal doctrines such as the legal doctrines for the defence of breach can be explained by risk allocation, agency rules and eoonomic efficiency. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 59 2 U ncertainty and Risk in Hold-up M odel 2.1 Introduction A decision maker faces uncertainty when she is unable to assign probabilities to future events and she faces risk when the probability of future events are known. In economics and game theory, risk and uncertainty have been mod eled similarly. There is much evidence in decision theory showing that deci sion makers often respond one way in uncertain environments and another way than risky environments. Experiments (Ellsberg, 1961 and Camerer and Weber, 1992) have shown that uncertainty plays an important role in deci sion making and it is worthwhile to spend some effort to study what happens when agents are uncertain. In this chapter we look at decision makers who face uncertainty in con tractual relationships. Agents write contracts to trade some time in the future. The contract to share risk between the agents or to reduce hold up in trade. Since writing contracts, and the contractual relationship itself in volves trade in future, agents have to make decisions involving future events. Agents, who make the decisions, often can find themselves in risk environ ments and uncertain environments. While most contracting literature has R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 60 studied contracting under risk, there has been little work on contracting un der uncertainty (Mukerji, 1998). As mentioned earlier there is evidence from experiments that decision makers do behave differently under uncertainty compared to risk. The fact that uncertainty is different from risk is also sup ported by the existence of legal rules which make distinction between the two. The foreseeability of harm doctrine and the impossibility doctrine both make a distinction between what is uncertain, i.e., the agents cannot assign proba bility to certain events and what is risk,i.e., that is the agents do not know if an event is going to occur in future but they are able to assign a probability to measure to it. The important question is if whether anything more can be explained by modelling contracting under uncertainty than already have been explained by modelling risk. In this paper we intend to partly answer this question by looking at certain contracting situations where the agents are faced with uncertainty. We look at three different contracting situations and see if there is a qualitative difference in modelling risk and uncertainty. Contractual relationships are often fraught with uncertainties. In con tracting situations for instance if two agents are contracting to trade some time in the future they might not have knowledge about what events may occur, or their information about the future may be vague and they may not R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. be able to represent their information with a probability measure (Mukerji, 1998). A contracting party may also be faced with uncertainty if she does not have much information about the other contracting party and is, there fore, uncertain as to how the other contracting party will behave. Here we analyze three different contracting situations and compare the differences in outcome by modeling risk versus uncertainty. We look at a standard bilat eral trade hold-up model developed by Holden (1999) to see if uncertainty makes any difference. In Holden’ s model, if agents are risk averse then there is no renegotiation and no hold-up. We show that if agents are uncertainty averse, the result is similar to Holden’ s result, there is no renegotiation of the contract. In the second model, we analyze again a joint ownership hold-up model. In joint ownership the initial contract is a share contract. If the initial contract written is a share contract then there is a difference between risk and uncertainty. If the realized surplus from the relationship is larger than specified in the initial contract, the contract will be renegotiated if the agents are risk averse but not if the agents are uncertainty averse. The third contracting situation we look at is again in a bilateral trade environment when the agents are uncertain about what the other agents are going to behave. We analyze a standard renegotiation game in the hold-up R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. model with players uncertain about the other players’ strategy. Games with uncertainty about other player’ s strategies has been analyzed by Dow and Werlang (1994), Klibanoff (1996) and Lo (1995). The equilibrium concept used is Multiple-priors Nash Equilibrium defined by Klibanoff (1996) and Lo (1996). The game form used here is the contract bargaining game described in Macleod and Malcomson (1996). Using Multiple-priors Nash Equilibrium, the number of possible equilibria increase, i.e., more number of strategies can be supported by Multiple-priors Nash Equilibrium than standard Nash equilibria. In the contract bargaining game no trade is also an equilibrium strategy. This no trade is equivalent to a dispute in a relationship as observed in a strike or lock-out. The result is driven by the fact that the player are uncertain about the other players’ strategy and therefore choose no trade action. 2.2 D ecision M aking under Uncertainty. The subjective expected utility axiomated by Savage( 1954) has been the most popular model for studying decision making under uncertainty. In the Savage model beliefs of the decision maker are represented by a probability measure. Empirical evidence, however, shows that the Savage model does not R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 63 always work and specially in situations when the decision maker is unable to assign probabilities to future events. The first such empirical evidence was provided by Ellsberg (1961). Ellsberg performed a version similar to the following experiment. An urn contains ninety identical balls of different colors. Of the ninety, thirty balls are black and the remaining sixty are either red or yellow. One ball is drawn at random from the urn and there is corresponding payoff. The following six bets are offered. 1. If black is drawn then the payoff is $100, and zero dollars if anything else is drawn. 2. If red is drawn then the payoff is $100, and zero dollars if anything else is drawn. 3. If yellow is drawn then the payoff is $100, and zero dollars if anything else is drawn. 4. If red is drawn then the payoff is $0, and $100 dollars if anything else is drawn. 5. If yellow is drawn then the payoff is $0, and $100 dollars if anything else is drawn. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 64 6. If black is drawn then the payoff is $0, and $100 dollars if anything else is drawn. Most decision makers when faced with the above bets exhibit the prefer ence ordering 6 y 5 ~ 4 and 1 > - 2 ~ 3. This result is not consistent with the Savage model. The prediction of the Savage model for the above bets is 1 2 ~ 3 and 4 y 5 ~ 6. The reason for this is that the Sure Thing Principle fails. The Sure Thing Principle which states that if a decision maker prefers A to B in case of any event then the decision maker prefers A to B. Further listing of empirical proof of violation of the subjective expected utility model is given by Camerer and Weber (1992). In recent decades number of economic theorists have developed axiomatic decision theories which allow Ellsberg-type preferences. The first few theories are attributed to Schmeidler (1989), Gilboa (1987), Bewley (1989) and Gilboa and Schmeidler (1989). Schmeidler (1989) proposed the Choquet exepected utility (CEU) model. In the CEU model the preferences are represented by the Choquet integral of the Bernoulli utility function with respect to non additive measure, called capacity. The decision maker is uncertain over the state space S = {s*}^. An act is defined as / : — > 3?. A capacity /i, defined on a set of states R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. S and algebra E, is monotone and normalized if A, B £ E, A C B, then g{A) □ fi(B) and /j> (0) = 0 and g(S) = 1. The capacity is convex if for A ,B € E there is g(A U B ) > g(A) + g(B ) — g(AC\B). Therefore we can have n{A) + g(Ac) < 1. Schmeidler also introduces an axiom called comonotonic independence axiom. Two acts / and g are comonotonic if for no s and t belonging to the state space S, f ( s ) > ~ /(f) and g(t) y g(s). The axiom states that for all comonotonic acts f,g and h and for all a £ ]0,1[ : f y g — > a f + (1 — a)h y ag + (1 — a)h. The notion of Choquet integral is for a non negative E measurable function 4 > : S — > 3?, the Choquet integral of ( f > with respect to capacity ir is fs^dg, — /0 °°/r({s £ S : < fi(s) > a})da. Therefore in case of CEU orderings the decision maker prefers an act / to act g if and only if Js u(f(.))dg > Js u(g(.))dg. Note that if the capacity is additive instead of convex then CEU is eqyuivalent to SEU. In this chapter we use the other theory which has been developed to in clude Ellsberg type preferences. This is the mulitple prior theory developed by Bewley (1989) and Gilboa and Schmeidler (1989). In this theory of un certainty the decision maker expects the worse outcome. For each event the decision maker assigns a set of probabilities. And the decision maker then behaves as a maxmin decision maker. There is a compact set II of probability R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 66 measures on (S, E). For a given function u we can define the multiple prior expected utility as min / ri(s)n(ds) venJs And if there are two acts / and g a decision maker who behaves as multiple prior expected utility maximizer will prefer / to g if and only if minvren fsu(f(.))JJ(ds) > m in ^ n fs u (g(-))H(ds). Note that if II = {tt} then the multiple prior expected utility is equivalent to subjective expected utility. And if capacity g as defined above is the lower envelope of its core, that is, g — minTen, then the choquet expected utility is equivalent to multiple prior expected utility. The measure of uncertainty can be defined as U(t t ) = 1 — ( t t (A) + ir(Ac)). 2.3 Under Investm ent Problem One of the main reasons contracts are written is to overcome the underinvest ment in a commercial relationship. Often in a commercial relationship, the participating agents make investments in the relationship which enhance the total value of the trade. This relationship-specific investment is most often unobserved or even it can be observed it is not contractible. After the invest ments, when the players realize the state of nature, one of the participating R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 67 parties may choose to hold up trade in order to get all the trade surplus. If one of the players hold up trade then the other party fails to get back any return from the relationship specific investment. Due to this probability of being held up at the time of trade players underinvest. Contracts help to mitigate this problem. But since contracts are incomplete the hold-up and the under investment problem may persist. 2.3.1 Bilateral Trade A risk neutral buyer B and risk seller S write a contract and enter into a long term relationship. During the relationship they make non-contractible relationship-specific investments as described in Hart and Moore (1988). Be fore the parties are about to trade, one of the trading parties can disrupt trade and hold up trade. The time line is the following, at date 0 the parties write a contract P°, at date 1 the buyer and the seller makes the relation specific investments ib and is respectively. At date 3 the state of nature a G E , where E is the set of states, is revealed. After which the parties can renegotiate and trade. The payoff for the buyer is ub(a) — P — ib and the payoff for the seller is us(cr) + P — i8, where P is the contract they choose to trade at, it can be the initial contract P° or a new contract. Though the R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 68 agents are risk neutral, they are uncertainty averse. The agents have a threat point b(a) for the buyer and s(a) for the seller where a € A = {aH, a L}, is a random variable, a is unknown is before trade is disrupted in date 3, but is realized as soon as trade is disrupted. It is assumed that at date 3 a contract P can be found such that trade is always efficient ub(cr) + us{cr) > b(a) + s(a) for all a. The buyer will therefore disrupt trade only iiu b—P — ib > ub—P °—ib and the seller will disrupt trade if us + P — is > u s + P° — is where P is the renegotiated price. If the event ub — P — ib > ub — P° — ib or us + P — is > us + P° — is fails to occur then there is no renegotiation anyway. As mentioned above it is efficient to trade at date 3. At date 3 the following game is played. The buyer offers P b, which the seller can accept or reject. Acceptance ends the renegotiation process. If he rejects the offer, the seller decides whether to disrupt trade or to continue the process. If he decides to continue he makes an offer. If he decides to disrupt then a renegotiation process takes place resulting in the Nash bargaining solution. The same process is repeated if the seller makes the first offer. An example of disruption is strikes when the seller disrupts trade or lock outs when the buyer decides to disrupt trade during labor bargaining. The Nash bargaining R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 69 solution, which results after there is disruption, will depend on a E A = {a x, a i}. a is realized by the agents immediately after the agents disrupt the relationship. The renegotiation process is specified, and if either of the players are going to be better off with the initial contract than with the renegotiated contract, a threat of disrupting trade will not be credible and no renegotiation will be induced. The possibility of renegotiation results in the players investing inefficient specific investments (Hart and Moore, 1988). If the players know or expect that there will be no renegotiation then the players invest efficiently. Uncertainty Decision makers are often uncertain about future events of the world, because the information the decision maker has is ambiguous, and this information cannot be represented by any probability measure. In the hold-up model described above the agents’ threat point depends on a € A = {an, oil}- The Nash bargaining outcome depends on the a. The states influence the threat point of the players. We assume that only the outside option of the buyer affects the bargaining outcome. If the state is o lh when either of the player disrupts trade then the threat point of the buyer is b(otH), and the threat point of the seller is s ( o c h ) and the Nash bargaining R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 70 solution is P (olh) and if the state is then the outside option of the buyer is b(ai) and Nash bargaining solution is P{o ll)- In the Savage world the states are {a#, oil} and the outcomes are {P (an), P ( c xl)}- Without the loss of generality we assume that P (c h h ) > P (a i)- The agents are uncertainty averse regarding the states o lh and o c l . They assign probability tP h to a # and t P l to a L. Since the players are uncertainty averse, the probability function is non additive and 7 + naL □ 1. The agents believe before they walk out that the bargaining out come is going to be F (a ^ ) with probability 7r“H and P (c c l) with probability iraL. Since the agent is uncertainty averse the agent forms Choquet expectation of the outcome in case he disrupts trade. Therefore if CE(ub) > ub ~ P° — ib, the buyer will disrupt trade and the if C E(us) > u3 + P° — is the seller will disrupt trade, where CE{u) is the Choquet expectation. P ro p o sitio n 1 Let the initial contract between the risk neutral buyer and the seller be p ° . If the agents are uncertainty averse in the Gilboa -Schmeidler sense about the state {a#, ol} which is reached once there is disruption of trade and the probability of a # is 7 rQ H and probability of aq, is 7 r aL, then the agents are not going to recontract and use the initial contract if P® < P ° < P® , where P f, P® are expected payoffs estimated using Choquet expectation. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. Proof. Let the buyer expectation of the bargaining outcome be P® = C E (P (a)) = 7 raHP (aH)+naLP (aL)+ (l— T T aH~TTaL) max[P(ai ), P{aH)) wlog lets assume that P { o l e ) > P{cx,l)- Similarly the sellers expectation of the outcome is P f = CE(P(a)) = iraHP(aH)+TTaLP (aL)+ (l— KaH — 7 r aL) min[P(ajr,), P(oh)] Let the Choquet expected utility of the buyer be CE(ub ) =iraH[ub — P{cx.h) — ib ]+TraL[ub—P(q>l)~~ ib \ + (1— 7 r“H — iraL)[ub— P (aH) - ib } and the Choquet expected utility of the seller be CE(us) = 7 r“fl[tts + P{atH) ~ P] + naL[us + P(&l ) ~ ~ P] + (1 ~ KaH — 7 raL)[us + P(otL) — is] The utility if there is no renegotiation is for buyer : ub — P ° — ib for seller : us + P ° — is Therefore the buyer will not want to renegotiate if C E(ub ) < ub — P ° — ib or P ° < (1 —7 raL)P(aH) + T r 0 ‘ LP(ai,) the seller will not renegotiate if C E(us) < us + P ° - is R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 72 or P ° > iraHP(otH) + (1 — 7 raH)P(ax) If a contract P° is written initially such that P f < P ° < Pff then the contract will not be recontracted. Now if we define coefficient of uncertainty aversion as c= (1 — 7 r"H — t P l ) Then we can see that a higher c will mean more likely that the players are not going to renegotiate. ■ This result is similar to that of Holden (1999). Holden (1999) shows that if the agents are risk averse then there will be no renegotiation and there will be no hold up. We have shown that the Holden(1999) result does not change if the agents are uncertainty averse as opposed to if the agents are risk averse. The Holden result of no renegotiation and no disruption of trade holds true because, since the agents are risk averse, the size of the expected return from the disruption of trade shrinks. With uncertainty averse players the size of the return from disrupting trade shrinks further. Holden shows that if there is a initial contract P° such that P ba > P° > P sa, where P b a is the highest initial price the risk averse buyer agrees to pay rather than disrupt trade and P sa is similarly the risk averse seller will pay rather than disrupt trade, then there will be no renegotiation. And this will result in efficient investment by both parties. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 73 Proposition 2 [psa, p ba] c [P®,P^} This proposition basically states that an initial price contract P ° which does not belong to [Psa, P ba] may not be recontracted if the players are uncertainty averse. Proof. A risk averse seller will not disrupt trade if E a{U{ub + P{a) - zs)] = U(ub + P sa - is) □ U(ub + P ° ~ 2s), The uncertainty averse seller will not disrupt trade if C E(us) U u s + P ° - i s. We know that Ea[U(ub + P ( a ) - 2s)] > C E(us) C E (f) = m in^E Sies f(si)irj(si),where s is the state, / is the act and t t is the probability measure. Therefore P f □ P sa Similarly we can show that P® > P ba. ■ Therefore not only will the players who are risk neutral not renegoti ate, neither will those who are uncertainty averse. Also, if the players are uncertainty averse then the range of initial contracts which results in no renegotiation is larger than when the players are risk averse. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 74 2.3.2 Joint Ownership This is a joint ownership model. Two players contract ex ante to trade and divide a surplus in future. The initial contract is a share contract. In the following contractual setting we show that with risk there will be renegoti ation while with uncertainty there will be no renegotiation and no disrup tion of trade. The buyer and seller get into a relationship to make possible trade in future. Ex ante they write a contract and then make relation spe cific investment ib and is. After which the state is realized and the buyer and seller decide to renegotiate and trade. The ex ante contract is a share contract { A is), (1 — A)< /> (ib,is)}, where (j>(ib,is) is the expected joint sur plus generated by investments % and is, A0(i^, i3) goes to the buyer and (1 — A )4>{ib,is) goes to the seller. Therefore if there is trade at this contract then the buyer gets A 4 > {ib , is) — ib, and the seller gets (1 — A)4> (ib, is)— V The renegotiation game form remains the same as discussed earlier with threat points b(a) for the buyer and s(a) for the seller where a € A = {a#, a^}. The uncertainty in the model is generated similarly to the one above and we maintain the same assumptions. If the realized joint surplus is < j> {ib ,i3) then it can be shown that if the agents are risk averse there will be no rene gotiation and if the agents are uncertainty averse then also there will be no R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. renegotiation and no disruption of trade, and the players will trade under the initial contract. But if the realized joint surplus is 4 > (ib , i s), such that 4>(ib,is) > 4>(%,is) — X4>(ib,ia) + (1 — A)0(ib, i s), then we can show that in certain circumstances, if the players are risk averse then the contract will get renegotiated as one of the players will disrupt trade, but if they are un certainty averse then there will be no renegotiation given that the difference <p(ib,ia) — 4 > (ib , is) is wasted if the contract is not renegotiated. In case of risk: If there is disruption of trade and then the Nash Bargaining results in the split of the surplus according to the bargaining powers (XN ,1 — XN ). Let XN be the buyer’ s share of the joint surplus (f)(ib , is) . Let XE be the buyers expected share of the surplus, i.e., if there is renegotiation the expected renegotiated surplus share is XN. The buyers expected return if he decides to disrupt trade is going to be EU(XNrf> (ib , ia)— % )■ If the buyer does not disrupt trade and decides to get what the initial contract was offering then the buyer will get U(X(f>(ib, is) — ib). Let Xb be the share parameter at which the buyer is indifferent between disrupting trade and trading at the initial contract. Therefore EU(XNrf>(ib,is) — ib) = U(Xb< f> ( ib , is) ~ % )■ Therefore Xb is the share at which the buyer will not want to disrupt trade. Since (j>(ib,ia) > 4>{ib,is), EU(XN(/> (% , is)— ib) > U(XE< f> (ib , is) — % )■ This is R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 76 the Jensen’ s inequality. This implies that because of a larger surplus the buyer will be willing to disrupt trade and force renegotiation. P ro p o sitio n 3 If the initial contract between players is {A is), is)}, and if the players are risk averse about the state a £ A — { o l h , o l l } which affects their threat points then the initial contract will get renegotiated to {ANf( ib,is), (1 - A N)$(ib, i s)}. Now let the players be uncertainty averse about the events {a#, a L} and the probability attached to c xh is iraH and the probability attached to ax is 7 raL . In the state a H the Nash Bargaining solution share is A(a#) and in the event ox, the Nash Bargaining share is A (ox)- Let us assume A (an) < A (o^). If both, the buyer and the seller, are uncertainty averse agents we get the following proposition. P ro p o sitio n 4 Let the initial contract between the risk neutral buyer and the seller be {A0(zj,, is), (1 — A )< !> (% ,ia)}- If the agents are uncertainty averse in the Gilboa -Schmeidler sense about the state {oi}i=/r,L which is reached once there is disruption of trade and the probability of a # is uaH and probability of u l is 7ra i for the agents, then the agents are not going to recontract if the uncertainty averseness c = (1 — tA h — ixaL) > c*, where c* > 0. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 77 Proof. Let the buyer expectation of the bargaining outcome be Af = CE(A(a)) = iraHA(aH)+iraL A(a£,)+(1— ■ 7 r “H — ixaL) min[A(ai), A(a#)] wlog lets assume that A {an) < A (otif). Similarly the sellers expectation of the outcome is Af = CE(A(a)) = iraH A(ajff)+7raL A(ax,)+(1— 7 r“H— - ir aL) max[A(a!jr,), A(a#)] Let the Choquet expected utility of the buyer be CE(ub ) - iraH[A(a.H)G>{ib, *s) - i& )] + [A ^ l)^ * ,, is) - % } + (1 - iC1 1 - -KaL)[A(aH)4>(ib,is) - i b] and the Choquet expected utility of the seller be CE(us) = itaH[ ( l - \ ( a H))4>(ib,is) - i8 ] +iraL[{l - X(aL))4>(ib, is) - is] + (1 - 7 rQ H - 7 raL)[(1 - A{aL))^{ib, is)) - Q The utility if there is no renegotiation is for buyer :X(j)(ib, is) - ib for seller ; (1 — X)(f)(ib, is) — is Therefore the buyer m il be indifferent when TTaH [A {aH)(4>(ib, i s) - i b )}+naL [X(aL)< f> (ib , i s ) -ib\+c* [A (aH)(f> (ib, i s ) -ib) = A (f> (ib , 'Ls) lb and will not want to renegotiate if CE(ub ) < A < f> (ib,is) - ib R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 78 or 7t“h [A (an)Q(ib, Q - * ft)] + n aL[\(aL)(j> {ib , is) - ib ] + c[X(aH)f>(ib, is) - ib] < ty(ib> is) Therefore the buyer will not renegotiate if c= (1 — 7r“H — 7r“L) > c * Similarly the seller will not renegotiate if C E(us) < (1 - A )4> {ib, is) - is or7raH(l — \(aff))f>(ib , is) + (l — iraH)[(l — \(ai))^>(ib, is)] < (1-A )< /> (% , if) or c = (1 — 7 — 7 raL) > c * Therefore if a contmct is written such that the surplus 4> (ib, i s) is shared such that \<j){ib, if) goes to the buyer and (1 — A)(f> (ib, if) goes to the seller the contract will not be renegotiated as long as the above conditions hold. Now if we define coefficient of uncertainty aversion as c = (1— 7rQ H — 7 rQi). Then we can see that a higher c will mean more likely that the players are not going to renegotiate. ■ This result says that if the joint surplus is larger than the sum of the shares of the surplus as mentioned in the initial contract then if the agents are uncertainty averse then there may be cases that there is going to be no recontracting. This is in contrast to the fact that if the agents are risk averse and the realized surplus is larger than the sum of shares mentioned in the contract then there will be disruption of trade under the initial contract and R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 79 there will be renegotiation. The reason for this is that with a larger surplus realized ex post, the players expect a reduced size of surplus if they are risk averse. But this expected size of the surplus is larger than the return if the initial contract is used. If the players are uncertainty averse then the expected size of the surplus reduces further and this can be smaller than the return from the initial contract. In this case the players are not going to renegotiate. 2.4 N o Trade Result The hold-up problem is the same one that is discussed above with the initial contract P°. The players have ex post payoffs uj, — P° for the buyer and us + P° for the seller if they use the initial contract to trade. After the states are revealed the players can find them in either of the following situations. • — u8 > ub • ub > - u s > P° • ub > P ° > -IIs • P° > ub > — us R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. In the last three states trade is efficient but when the state is ub > — us > P° the seller does not want to trade and when the state is P° > ub > — us the buyer does not want to trade. In the former case the when the seller does not want to trade but the buyer wants, the buyer, makes the first offer. It is clear that he has all the bargaining power. In the latter case the seller wants to trade and he makes the first offer. The bargaining is a form of the ultimatum game. The game form: If the state is ub > — us > P° buyer makes the first offer: The buyer makes an offer P n, the seller accepts (A) or rejects the offer (R). If the seller accepts the offer then the contract price is P n and if the seller rejects the offer then the contract price is P°. In either case if the seller accepts or rejects, the buyer decides to trade(T) or not to trade (N T). If the buyer chooses no trade the game ends with the buyer getting his outside option b and the seller gets his outside option s. If the buyer elects to trade, the seller moves next and chooses between trade(T) and no trade(iVT). If the seller chooses no trade then the game ends with the players getting their outside options and if seller chooses to trade then the game ends with the ex post payoff ub — P and us -T P. In case the seller makes the first offer the game form R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 81 remains the same only that the seller moves first and the buyer accepts or rejects the sequence of apart from the switch between the person who offers and accepts And if the state is P° > ub > ~ u s the seller moves first and the moves are reversed. Both players have a discount rate of 6. If the players are neither risk averse or uncertainty averse then just using subgame perfection we get the following result. P ro p o sitio n 5 (% ) If the buyer moves first the SPE is P ™ — us ifu 3 > s and Pn = s if us < s and (ii) if the seller moves first then the SPE is P n = ub if ub > b and P n = b if ub < b. And both will trade. This result is similar to a take it or leave it game, where the player making the offer matches the outside option of the other player to ensure that he participates and keeps the rest of the gains from trade for himself. The player making the offer keeps all the surplus after giving the other player his outside option. 2.4.1 N ash Equilibrium under U ncertainty If the agents are uncertainty averse (have multiple priors) and multiple-priors Nash Equilibrium is used. The buyer is uncertainty averse. Thus the beliefs R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 82 of the buyer over S~i, the strategy set of the seller are represented by a closed and convex set of probability measures IX j. The probability measures have the support M_j. I* E Ij is the information set. D efinition 6 { IT } ^ is a Multiple-prior Nash Equilibrium, if 1. There exists a closed and convex set of probability measures H (h) Q E(A(Ij)) for all Ii,where E is the support of all probability measures over actions A in the information set T, such that Ilj = closed convex hull of { x ^ X/^gi- ir(Ij) | w(Ij) E JJ (Ij)'VIj, i j} 2. Every Sj min Y1 ui(si,s_i)7ri(s__j) > min s_i)7ri(s_i) for all Si if {n is a Multiple-prior Nash Equilibrium then there is a Nash equi librium { r h } ^ such that € IH j. This also means that a Nash equilibrium will be contained in Multiple-prior Nash Equilibrium. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 83 In case of extensive games, the players update their beliefs using the Generalized Bayesian rule (Depmster Shafer Rule) rather than the Bayesian updating. Genaralized Bayesian was axiomatized by Gilboa and Schmidler (1993). Given that the decision makers have a set of priors, the decision mak ers update their beliefs by considering only those priors which attach maximal probability to the event that has occurred. After this, the priors are updated according to Baye’s rule. And as the decision makers update their beliefs, ambiguity or uncertainty is reduced. Therefore with non-additive measure, according to the Generalized Bayesian rule, the decision maker’ s beliefs con verge to a single additive prior. After the players make a choice based on their multiple prior expected utility in the first stage, they realize the true state. Based on the true state the players make the choice in the second stage after updating their beliefs according to the Generalized Bayesian rule. P ro p o sitio n 7 In the renegotiation game with the buyer making the offer, using Multipk-priors Nash equilibria the set of outcomes include ((Pn, N T ), (A, NT)) and ((Pn, T), (R, T)). Proof. Under the following states renegotiation occurs: (i) ub > — us > P° and (ii) P° > u b > —us, while under the former the seller moves first in the latter the buyer moves first. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. (i) I f the buyer offers and the seller rejects or accepts, the buyer can trade or not trade followed by the seller choosing to trade or not to trade. The buyer is uncertainty averse regarding the choice of seller’ s trade and no trade. If the buyer offers P n and the seller accepts then the buyer chooses his action. The buyer before he decides to move has beliefs about the action to be chosen by the seller next. The buyer attaches a probability ttn t = 0 to no trade since he is sure that the no trade action will be chosen with a zero probability. The buyer attaches a probability rrT to trade, such that 0 < irT < 1. Therefore, the buyers expected payoff is t t T[ 6(ub — P n)] H - (1 — irT)[6b}. For some 7 rT € { tl~) we can have irT[6(ub—P n)] + (1— irT)[8b\ □ b. The buyer will choose no trade instead of waiting for the seller to choose trade. Therefore the equilibrium ((P n,N T ),( A ,N T )) can be supported. Formally following the above definition we could write the Multiple-prior Nash equilibrium as P « ) = p n , E ( ^ i ) = A M I» 2 ) = N T I l M = {?r £ M ({T, N T }) | 0 < 7 rT < 1}, H (Is3) = {x £ M ({T, N T }) j 0 < 7 rT < 1} where {ff) is the jth information set of player i. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 85 If now the buyer offers P n and the seller rejects, then again the buyer has beliefs about the seller’ s next action (T, N T ) before his own moves. Since the seller does better by choosing N T , the buyer attaches it1' = 0. Since he is uncertainty averse the probability irNT that the seller chooses no trade is 0 < irNT < 1 . I f uncertainty is high then the following can be true (1 —irNT)[6(ub— P°)\ + 7 rNT[S b ] > b. In this case the buyer will choose T and the equilibrium can be ((P n,T ) ,( R ,T )) supported. Formally another Multiple-prior Nash equilibrium is TIM = ^ n ( ^ ) = ^ r i ( 4 2)=T 11(^2) = { - 7 T e M ({T ,N T }) | 0 < irNT < 1}, 11(1*3) = {7r € M ({T, N T }) | 0 < irNT < 1} In case of (ii) the seller moving first we can get a similar result. ■ This result is due to the buyer’s belief about the seller’ s decision to trade and not to trade. If the buyer observes A being chosen by the seller and he is still not sure what the seller is going to do next, his belief is given by a set of probability measure II = {7rT € M (T, N T ) \ m □ 7tt □ The buyer expecting the worst puts the least amount of wait on the good outcome. This R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 86 outcome differs from a standard SPE, in which case the buyer is Bayesian and the buyer puts a weight of one on the strategy that gives him the highest payoff since he knows the seller will be willing to trade. The buyer might have a set of probability measure (become uncertainty averse) if he observes the seller rejecting his offer. Similarly if the buyer observes R by the seller, his set of probability measure is give by the following II = {k nt e M(T, N T ) I 3 L □ t tNT □ Including uncertainty within the game increases the set of equilibria. While trade is a possibility, possibilty of no trade cannot be ruled out either. This is because the players cannot rule out strategies, which they would be able to if Nash equilibrium was used instead of Multiple Nash equilibrium. Under uncertainty the players attach positive probability to strategy which would never be played under Nash equilibrium. If uncertainty is defined as (1 — 7 rT — t t n t ), then as uncertainty increases the possibility of no trade will also increase. This result is in contrast to the result obtained with risky players playing the game instead of uncertainty averse players. If the players are risk averse then the payoffs are u(ub ~ P n) and u(us + P n) for the buyer and the seller respectively, if there is trade at Pn and u(b) and u(s) if there is no trade. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 87 P ro p o sitio n 8 If the players are risk averse and the discount rate of the players is such that 6 > —^ then the SPE (i) when the buyer makes the first offer is P n — u(us) if u(us) > u(s) and P n = u(s) if u(us) < u(s) and (ii) if the seller makes the first offer then P n = u(ub ) ifu (u b ) > u(b) and P n = u(b) if u(ub) < u(b). And both will trade. If the players are risk averse then we get the trade at an equilibrium price lower than when the players were neither risk nor uncertainty averse. In the game when the buyer makes the first offer and then decides to trade or not to trade, he attaches a probability tin t = 0 for the seller choosing no trade. As a result the probability that the seller is going to choose trade is 7 rT = 1 (additive probability). So the SPE offer is going to be such that the seller is put back to reservation utility. 2.5 Conclusion In this chapter we get some simple results when uncertainty, as character ized by Schmeidler (1989), is included in a contract bargaining game. Though decision makers often face uncertainty, uncertainty is rarely modelled in eco nomic theory. Uncertain future is generally modelled as risk where the agents have subjective probabilities of future events. In the Holden model we see R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. that uncertainty does not change the result. But in the same set up if the type of the ex ante contract is changed to a share contract we see that uncer tainty still gives no renegotiation, but with risk we do get renegotiation. The main reason is that if the agent is uncertain then he expects the worst and the expected outcome is smaller than if risk is used. In the second model by using Multiple-Priors Nash equilibrium we see that the possible set of equilibria is larger than what we would have got by just using standard Nash equilibrium. It is difficult to say whether much is gained by using uncertainty averse agents rather than risk averse agents in case decision makers are not able to foresee the future perfectly. Uncertainty averseness causes the agents to expect the worst outcome, and in some sense is an extreme form of risk averseness. But modelling uncertainty averseness does provide an interest ing insight into decision making when agents are unable to attach subjective probabilities to future events. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 89 3 C onstruction Contracts: A Cost Overrun M odel 3.1 Introduction An important ingredient in the formation of any contract is the complexity of the good being traded. Recently Bajari and Tadelis(2Q01) have shown that complexity can help explain whether parties use fixed price or cost plus terms in constructions contracts. They do not however address the question of the appropriate design of damage rules for contracts that are litigated in court. This is an important question because 8-10% of constructions, as compared to about 3-4% of general contracts (Acret (1999)), result in disputes settled before a judge. The purpose of this chapter is to explore the structure of opti mal damages as a function of the complexity of the relationship. W ith lower complexity expectation damages induce higher investment by the contractor and with higher complexity under certain conditions the reliance damages can induce higher investments. Expected damages induce highest specific investments from the agent when the owner has bargaining power, and if the agent has all the bargaining power then the reliance damages induce more effort. While there is a large literature which ranks different damage rules to induce specific investments by the contracting parties (Shavell (1984) and R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 90 Rogerson (1984)), they have not looked at the characteristics of the good being traded. One important aspect of contracting is complexity of the project. Com plexity can increase the cost of contracting. If a simple standard product is being traded the cost of contracting can be negligible but if the product is complex (for example a high rise building) then the cost can be considerable. And as Schwartz and Watson (2001) has shown that this can lead to differ ent contractual forms. Complexity not only may lead to different contractual arrangements but may also require different legal remedies. Another result of complexity of the product being traded is the higher probability of renegotiation. Higher complexity may lead to higher contract ing costs. This may result in more incompleteness of contracts and therefore more renegotiation. As we observe from the evidence in the construction in dustry, large number of contracts face cost overruns and end up in court. Our model features an unbounded support assumption for the costs to motivate higher cost overruns observed and a motivation to go to court. We address the owners problem of writing a contract such that the con tractor makes sufficient relation-specific investment and there is ex post ef ficiency. We focus on the cost overrun feature of the construction industry. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. The owner and the contractor write an ex ante contract and then make spe cific investments in the project. We show in this paper that though more complex forms of standard contracts are available, the contracting parties generally use simple contracts cost plus or fixed price contracts (Ibbs et. al. 1986 ppl06-107), and (Bajari and Tedalis, (2001). If the project is simple and the owner can provide full design at low cost then a fixed price contract is written. The probability of recontracting is lower in this case and the owner prefers to write a fixed price contract. Also if the project is complex, cost plus contract are preferred by the owner. We show that if a cost plus contract is written then there is no renegotiation, and therefore, the owner is protected from the loss of surplus through renegotiation. As aresult, agents might choose to write different type of contracts depending on their bargain ing powers in the ex post game In addition to the above results we model legal rules. Using our model we acoess the damages which can be used in the construction industry to induce the contractor to put in maximum relation specific investment. As a result of the investment the contractor reduces his own costs. Large number of con tracts have cost overruns, and because of this there are a disproportionately a large number of construction contractual disputes which finally end up in R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. courts (Acret(1999)). The primary reason for cost overruns is that contracts are incomplete. In the above analysis the damages are modeled as liquidated damages affecting the bargaining outcome in the renegotiation stage. We characterize the damage which the owner would choose in order to induce maximum investment from the contractor. We show that expected damages dominate reliance damage by inducing more relationship specific investment by the contractor. The reason is that if expectation damages are used, the contractor does not try and renegotiate the contract, while if reliance is used the contractor will try to renegotiate. Since there is no renegotiation with expectation damages the contractor invests more with expectation. This result is similar to Shavell (1980) but quite different from Che and Chung (1999). Che and Chung (1999) show that expectation damages may not be the best damage rule to use if the investment by the agent is cooperative. In our model though the investment made by the agent is cooperative we get the reverse result. But if the contractor has all the bargaining power in the renegotiation stage of the game then reliance damage induces more effort by the contractor. A legal doctrine which protects the breaching party and works as a de fence for the breaching party is the impossibility doctrine. This doctrine R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 93 grants relief to the contracting party if an unexpected event occurs and if the risk of this unexpected event had not been allocated to the performing party in the contract. After this event has occurred the performance of the task has been rendered commercially impossible (U.C.C.J|k2 — 615(a)), then the impossibility defence can be used by the breaching party (Transatlantic Financing Corp. v Unted States, 363 F.2d 312 (1956)). In this chapter, we show that this has adverse effect on the incentive of the performing agent. And even if the agents are risk averse a positive damage is always Pareto improving. This result shows that in some cases not using the impossibility doctrine to grant relief to the agent will enhance the trade surplus. The other main result of the paper is that we formalize why such a high number of contractual relationships in construction industry have cost over runs. This result is in line with the discussion in Tirole (1986). The players ex ante when they write the contract choose an anticipated cost. We show that this is always less than the expected cost of the project thus resulting in a high probability of cost overruns. The reason is that the cost of describing costs ex ante increases as described cost nears expected costs and also since lower anticipated costs means a lower fixed price part in the contract. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 94 3.2 C onstruction C ontracts Studying construction contracts raises interesting issues of hold-up, authority relationship and disputes. Relationships observed in construction contracts are far more adversarial than most relationships. Contractual disputes and law suits are far more frequent in construction industry than disputes in other commercial enterprises. The reason for higher number of law suits in construction contracts is because of undercapitalized contractors, who find it difficult to meet contractual obligations and often face cost overruns. The second reason for a high number of disputes is that the relationships in the construction business are non repetitive in nature as most of the work is unique. Also disputes in this industry are interesting as they involve mul- tiparties like owner, architect, engineer, prime contractor sub contractor, insurance and bonding company, material supplier etc. Contracts in construction industry are standardized (Sweet, 1994 and CB- CLE,1999). The whole contractual process includes bidding for the project, signing of the contract, changing made in the contract, arbitrating in case of disputes and going to court. The American Institute of Architects (AIA) and the Associated General Contractors (AGC) provide detailed and stan dard contract forms, as well as the general conditions and procedures to be R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 95 used. Most construction businesses use and follow the contract and norms provided by the AIA and AGC. These contracts are not only well under stood but help to keep legal rules in mind during interpretation of contract conditions. One of the main aspects of any contract is the payment arrange ment. This is not a function of the legal issues but basically depends on the professional and economic factors. Contracts are classified by method of pricing or by the amount of design. If they are classified according to the pricing method then they are either fixed price or cost plus contracts. A fixed price contract can be a lump-sum contract or a fixed unit price contract. In this case complete specifications are generally given. The contract sum is decided when the contract is decided. This contract sum is decided on the basis of the tasks agreed upon by the owner and the contractor. Variant fixed price contracts that are observed are contracts which include a) target costs; b) target profits; c) ceiling price and d) sharing formula. In a cost plus contract, generally the contractor is reimbursed, generally every month, all the cost plus an amount ( fee) to compensate for the overhead. The fee is usually 2 to 15 percent of the contract price. The type of costs which are to be reimbursed are described and usually include labor, materials, subcontract costs etc. These type of R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 96 contracts are generally used for unusual projects or novel projects that do not need a high degree of specificity in drawings. For both contracts, progress payments are made once every month or once every fortnight depending on the agreement, and then,at the end of the project, the left over is paid. Another classification of construction contracts is done according to the extent of drawings and specifications (Sweet1994, CBCLE1999). The com plete drawings contract is where the owner furnishes complete drawings and specification to the contractor at the time the contract is written. The next type of contract is the design build contracts. Under this type of contract the contractor is responsible for the design. The owner specifies the desired performance parameters and the contractor uses standard components and details to reach the desired outcome. Finally there are the fast track con tracts. In a fast-track contract, the contract is signed before entire project is completely described, or before the designs and specifications are com pleted by the architect. Fast-track contracts are used when the project needs to be completed in a hurry due to high interest rates or limits on land use entitlements. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 97 3.3 Explanation In the above description of contracting in construction industry the following features stand out. • high level of cost overruns, and the level of cost overruns increase with complexity of the project. • use of ex ante contracts which are either fixed price or cost plus (though more forms of contracts are available). • contracts are renegotiated ex post. • ex ante contract influences the renegotiated outcome. • and since huge number of contracts go to court due to disputes the type of damage rule used in the court has a considerable effect on the relationship. In our model we aim to capture and explain the above features in as simple a framework as possible. We build a model where costs are unbounded. This makes it almost impossible to completely describe costs ex ante, or we can say it makes it very expensive. As the complexity of the project increases it becomes more expensive to describe costs. Complexity can be understood R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 98 here as the number of tasks the project can have or the number of possible ways to make the project. Therefore there is always a positive probability that a state will be reached which has not been described ex ante. If an unexpected state occurs then there is renegotiation of the contract. In the renegotiation stage the contractor has the option to breach the contract. This allows us to model damages in this framework. 3.4 Literature The related literature is limited. Most procurement contract literature has modeled the owner-contract relationship in a principal agent framework. In a standard principal agent framework it is assumed that the principal has su perior knowledge about the project. The principal offers a menu of contracts to the contractor from which the contractor chooses a contract which satisfies his participation constraint and incentive constraint. Asymmetry of infor mation is absent in the construction industry between the contractor and the owner. It is more reasonable to model procurement in the Grossman- Hart-Moore incomplete contract framework. Bajari &Tedalis (2001) and Bannerjee & Duflow (1999) have used the Grossman-Hart-Moore framework to model procurement contracts. Bajari and Tedalis (2001) also model the R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. construction industry. They explain primarily two questions as to when a fixed price contract should be used versus a cost-plus contract and what can explain the existence of simple contracts. Their explanation is in terms of transaction costs. Transaction costs can arise due to designing of project and if the contract gets recontracted. The main result is that fixed price contracts have higher transaction cost not only due to the fact that fixed price contracts are too expensive to draw due to higher design but also they are more likely to be recontracted compared to cost-plus contracts. Only if the transactions costs are low then the parties will write a fixed price con tract. In addition to the Bajari and Tedalis (1999) result of simple contracts we model damage rules. In our paper, the contractor has the option of walk ing away from the contract and breach. This option lets us introduce breach damage in the model. We analyze the optimal damage rule which induces the contractor to make the highest investment of care and promptness into the project. The damage in the model works by changing the threat point of the players during the renegotiation game. As mentioned earlier this paper also discusses breach damages in case of non performance. Shavell (1984), Rogerson (1984), Craswell (1988), Edlin and Reichelstein (1996) and Che and Chung(1999) have all discussed contract R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 100 breach, their damages, and what effect they have on the incentives of the contracting parties. While all these papers have looked at different legal damage rules and their effect on the investment by the different parties, we characterize the optimal damage rule in case of breach by the contractor. Damage is modeled similar to Shavell(1984) and Rogerson(1984) where the damage basically effects the threat point of the players in the bargaining game during the renegotiation of the contract. Shavell (1984) was the first to discuss and analyze the effect of dam ages on efficiency of trades. Shavell (1984) shows that if the damages can be measured precisely then the expectation damages is pareto dominant to reliance and restitution measure. And if the expectation damage is mea sured with an error then reliance is superior to expectation. Rogerson (1984) generalized ShavelPs results and extended it to include relationship specific investments. Rogerson (1984) looks at a buyer seller contract where the buyer or the seller makes reliance expenditures before trade. In this model both the buyer and the seller can hold up trade in order expropriate more rent from the other player. Given this framework Rogerson ranks specific performance, expectation damages and reliance damages. He shows that the expectation damages Pareto dominates reliance damages for all values of R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 101 bargaining power for the players. Specific performance can result in efficient investment but the investment generated is never higher than expectation damages. Edlin and Reichelstein (1996) analyzes specific performance and expectation damages and shows that specific performance and expectation damages gives first best relationship specific investment. Unlike the above papers Che and Chung (1999) discuses cooperative investment and they show that reliance does better than expectation damages. 3.5 M odel There is an owner O who contracts with a contractor C to build a project Q. The project has a exogenously given value v for the owner and the anticipated cost of building the project is given by c and both are common knowledge. This projected cost is not the expected cost of the project but an estimate which the owner and the contractor decide on. The timing of the moves of the owner and contractor is the following: 1. The owner chooses the amount of design r 6 [0,1]. A low r means the design is not well specified and not complete while a high r means the design is well specified and almost complete. The two extreme cases when r = 0, is a fast track contract or when r = 1 it is a complete R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 102 design contract. The cost of design is d (r,T ) where d() is a standard nondecreasing, convex cost function. The variable T is complexity of the project, where we are generally talking about task complexity. A project is complex if there are too many tasks involved in the project or the project is new such that the tasks involved are not well defined. 2. After the amount of design has been chosen the owner chooses the type of the contract (P, s). The component P is primarily the fixed price component and s £ [0,1] is the share of the cost of overrun the owner decides to bear in case the cost exceeds the true cost c. The owner therefore pays P + s(c — c), where c is the realized cost and c is the anticipated true cost. If s = 0 then it is a fixed price contract and if s = 1 then it is a cost plus contract, and anything in between the contract is mix of both cost plus and fixed price. The owner gets to choose the contract because, before the performance and the realization of the true state of nature, the owner holds the bargaining power. 3. After the contract has been signed the contractor makes relationship specific investment / ( in the Grossman-Hart-Moore sense). This in vestment can be thought of as the amount of care, diligence and prompt- R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 103 ness with which the contractor starts and approaches the project. This I is neither observable nor verifiable in court. Though this investment I is not contractible the owner would like the contractor to make this investment because this investment will reduce the likelihood of cost overruns. The cost of making this investment is a l. The contractor is unable to prove this cost to the court and therefore he is unable to set a price or get returns on this investment. 4. After the contractor starts the project the states are revealed u > i = (v, c(I)). Therefore the owner will realize the value v, but the contractor faces random costs and can face a cost other than the anticipated true costs. 5. After the costs are realized there is renegotiation and trade. As noted earlier the contracting parties when they write the contract form an anticipated cost c. The actual realized cost is given by c — ~ + e — I where e is the noise term. Higher I decreases the realized cost of the project. Now if the contractor makes no investment then the cost is c + R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 104 e where c is the anticipated costs and e is the cost overrun. The point probability of the costs being less than c is r and probability of costs being higher than c is (1 — t) . We concentrate in this model on cost overruns and the effect it has on contracting. If J > 0 then the initial point of the exponential function shifts left by the amount I and expected cost for cost is t(c — /) + (1 — t ) I (c + e — I)f{e)de. Jo After the costs have been realized, the contractor performs the contract, he can renegotiate the contract or just walk away after paying the damage to the owner. We will assume that the owner pays the price to the con tractor before he performs. This assumption is reasonable because in most construction cases the owner makes some transfer initially to the contractor and after that the owner makes payments periodically over the period of the contractor performance. Since this model is a one shot model it is reasonable to assume that contractor is paid before he starts performing. After the states of nature have been revealed, the contractor and the owner renegotiate and trade. The initial contract chosen is (P, s) where P is the fixed price component of transfer and s is the share of cost overrun borne by the owner. After he has realized the cost of project, at stage 5, the R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 105 contractor chooses to perform. If the contractor chooses against performing, i.e., breaching the contract, he pays a damage D (transfer) to the owner. Parties will renegotiate if the resulting benefits are larger than the costs. There is a cost of renegotiation, each party bears a cost a, thus the total cost of renegotiation is 2a. The renegotiation outcome is given by the Nash Bargaining outcome, and we assume that the owner has a bargaining power of A . The surplus from trade is (v — c) — 2a. Assumptions: 1. The function d() has the following properties di > 0,d2 > 0 , - ^ > 0 , £ g > 0 , d( 0, T) = 0, d (r, 0) > 0, d( 1, T) = oo 2. The variable e which gives the cost overrun is exponentially distributed e 6 (0, oo) with parameter j3. Apart from computational convenience, the exponential density function is justified in this present framework because exponential function gives the long right tail, that is the prob ability of high cost goes down but never to zero. 3. The realized costs are observable and verifiable, i.e., the contractor, the owner can observe the costs and any third party, including the courts, can verify it. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 106 4. The cost of renegotiation is an increasing function of the complexity of the project, er(T), </ > 0, a" > 0. P ro p o sitio n 9 In cost plus contracts (s = 1), there will be no recontracting. Proof. The contractor’s payoff ex post is P + s(c — c) —c. The contractor will refuse to perform under the existing contract if the cost is higher than some ci and the damage to be paid is some D such that P + s(ci — c) — ci = — D or P — s~ + D ci = -— 7--------- 1 — s As recontracting occurs only if cost is higher than , Since with cost plus contracts this goes to infinity there will be no recontacting. ■ If the realized cost is between cx and some O i such that v = c2 - 2 o(T) then the contract will be renegotiated. Beyond C 2, i.e., when v — C 2 — M T ) C j 0, no performance is optimal. This ensures ex post efficiency. T'he renegotiated contract is P + s*(c — c) — c, where s* is decided by the bar gaining power of the two players. The game form of the bargaining is: The R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 107 contractor chooses first to perform or not to perform. If he performs then the game is over with the players getting their payoffs after performance. If the contractor does not perform then the owner decides if he wants to negotiate or not. If the owner chooses to negotiate then the outcome is given by the Nash bargaining solution. We assume that the owner has bargaining power A and the contractor has bargaining power (1 — A). If the owner chooses not ne gotiate then the contractor moves again making a choice between performing or walking out. If he walks out he pays the damage. If there is renegotiation then under Nash Bargaining the owner gets (D + A((v — c) — 2cr)), and the contractor gets (c — D + (1 — A)((u — c) — 2a)). Therefore we see that if the realized cost c is less than the anticipated true costs c then the contract P is used if the realized cost c is c □ c □ cl5 then P + s(c — ~) is used, if c is such that ci □ c □ C 2 then the renegotiated contract P + s*{c — c) is used and if c > c2 then the contractor breaches and pays damage D. Further, the probability that the realized cost is less than the true anticipated cost c is r, and the probability that there is a cost overrun is (1 — r). For the time being let us assume that the cost of renegotiation is independent of T. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 108 3.5.1 Optimal Investm ent As a bench mark case, we discuss the first best outcome. The amount of design chosen by the owner and the amount of relationship specific invest ment chosen by the contractor is given by (r*, I*).(r*, I*) maximizes the net expected gains from trade conditional of the fact there is efficient trade. /■(c2— c + /) g fi£ I* € arg max w = r(v — c) + / (v — c)—— de — a l — d{r,T) JO fj /• (C 2 - C + J ) e ~ / f e = r l + (1 — t) ( / I —r—de) — a l — d(r, T) Jo p The f.o.c. with /3 = 1 is I* - log(l - I*) + log ■ ; + (w - c) = 0 i — r and since w" □ 0, I* is optimal, r* exists and is given by r{c2—~+I) e ~fiz t * 6 argmaxr(r> — c + / ) + (1 — r) / (v — c)~— —de — d(r,T) — a l Jo p t * 6 argm axr(v — c + 1) + (1 — r)(v — c + /)(1 — e- ^ 02-^ ^ ) — (1 — t)(1 — e“( C2_c+/)(c2 — “ + / + !)) — cf(r, T) — a / R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 109 3.5.2 Owner’s and C ontractor’s Problem The contractors maximization problem is given by the following, where the first term is the payoff if the contract is not renegotiated, with probability r, and rest of the terms are the payoff if the contract is renegotiated with probability (1 — r). And D is a general damage which the contractor pays if he decides to breach. m ax r(P — c + 1) + (1 — r)[ / (P — e — c + I)f(e)de /•(C 2 —“ + / ) + ((c — D) + (1 - A)(v - c - 2o))f{e)<k (ci — ” + /) + f . - TX ~ D ) f ( e ) d e \ - a I J (c2— C+J) where /(e) = . Assuming (3 = 1, and P = ~, the first order condition is: ( ! - « ) + e ^ C D = 0 R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 110 CD = (1 - r)( 1 - s)(l - e ^ ) - (1 - r) - (1 - r ) ( l - s ) e ^ - ^ + ( 1 - t)((1 - X ) v - D + c \ - 2 a ( l - X ) ) ( e - ^ - 2 < T ~^ ~ e ^ ) +(1 - r)( 2 - A ) e ^ ^ - (1 - r)(2 - X ) e - ^ ^ ~ " \v - 2 a - c ) + (1 - t) De~(v~2a~^ therefore the investment made by the contractor J = - b g ( ^ r ) The first result shows that the contractor always under invests even if there is a contract present and if he has all the bargaining power to get all the surplus ex post. The primary reason is that there is always a positive probability of reaching a state when performance is too expensive and the contractor will choose to breach. If in this state he has to pay a damage D > 0, then contractor will always under invest since he anticipates the possibility of such a state. P ro p o sitio n 10 Given the initial contract (P, s) and the design r and ex post bargaining power (A, 1 — A ) the amount of investment chosen by the contractor I is less than the optimal amount I*. Proof. The investment chosen by contractor is I = — log(-^?). The surplus is w = t (v — c) + fo°2 ~c+I\ v — c)^— de — a l — d(r, T) R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. I l l w \I ) > 0 w"(I) □ 0 I * e arg max to st I* — log(l — /*) + log + (v — c) = 0 since - logftjj?) - log(l + log(^jjr)) + log + (v - c) > 0 I □ I * . M C orollary 11 Even if the contractor is given complete bargaining power (1— A ) = 1, the contractor does not invest optimally. C orollary 12 ^ □ 0, the more cost plus the contmct the lesser the contrac tor invests other things remaining the same. P r o o f . I = - lo g ( ^ ) M - .... (Kff n 0 ds ~ CD{ 1 - a ) ds U U if ( l - + ( 1 - t ) ( 2 ~ □ (1 - T)(i - ef 3 ) + (i - 4- + ^ ) . This result says that if the A is high then the contractor’s incentive to make investments in promptness and care decreases as the contract becomes more cost-plus. This result is standard as it says that the incentives provided by cost plus contracts are weak and the fixed price contracts are better. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 112 As mentioned earlier the owner and the contractor choose to write a contract (P, s) before the project begins. The owner chooses the contract after he has invested r on design. The choice of r depends on the complexity of the project. A contract is written to provide incentives to the contractor. But at the same time, if the project is complex then, providing design for the project is expensive and there is a high probability of renegotiation, after which the owner might lose surplus to the contractor, even if we ignore the cost of renegotiation. Therefore there is a trade off between providing incentives to the contractor and the cost of writing a full contract. The owners payoff can be written as ir° = t ( v — P) + (1 — r) f (v — P)f{e)de + J 0 / ( c i- c + l) (v — P — s(c — t))f(e)d£ + (1 — r) (D + X(v — c — 2cr))f(e)de + rOO (1 - r ) _ (D)f(£)de~d(T,T) J(C2-C+I) where I = — log cd and d is the costof design and has the following proper ties: d\ > 0, o ? 2 > 0, > 0, > 0, d(0, T) = 0, d(r, 0) > 0, d(l,T) = oo. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 113 P ro p o sitio n 13 There exists a r* £ (0,1), such that for r £ [0, r*] the contract chosen is s = 1, and r £ (r*, 1 ] t/ie contract chosen is s — 0. If the owner spends relatively small amount of resources on design, then he will choose to write a cost plus contract. If the design is not complete or amount of design is not high then there is a high probability that a general linear contract will be renegotiated. Since the owner knows that in case of renegotiation the contractor can hold up the project he prefers to write a cost plus contract. As we have seen earlier the cost plus contract does not get renegotiated. A major factor which decides what kind of contract is written is com plexity T. Complexity is both how large the project is and how familiar the parties are in designing the project. If the project is big, or if it is something new then the cost of designing the project is going to be extremely high and it is most likely that the project will be started with an incomplete design. If the project has an incomplete design then the owner, as we have seen earlier, chooses to write a cost plus contract. We can see this from the following proposition: P ro p o sitio n 14 The design of the project t , is inversely proportionate to T if design increases the profits of the owner. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 114 P roof. Using the implicit theorem p p p j — .§sl(Lz), _ <n ar — a rc ^ u Depending on the parameters the following can be true —- < 0 or ^ > 0 . If > 0 then < o. ■ Therefore as long as design r increases profits, i.e., marginal returns of r is greater than the marginal costs of r, then as complexity T increases, design chosen goes down. The above two propositions are similar to the one proved by (Bajari and Tedalis, 1999). They show that as complexity increases the type of contract chosen is going to be more costplus. P ro p o sitio n 15 As the complexity T of the project increases the contract chosen by the owner is more cost plus, i.e., -jff > 0 . (Bajari and Tedalis, 2001). The above results primarily state that as the complexity of the project increases the owner will prefer to write a cost plus contract. The cost of contracting and the anticipation of losing surplus in the renegotiation takes precedence over the benefit of providing incentives to the contractor through fixed price contracts. These results have are similar in nature to (Bajari and Tedalis, 2001). R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 115 P ro p o sitio n 16 If the owner has no bargaining power in the ex post game A = 0, then the owner will write a cost plus contract and if he has all bar gaining power A = I,then he will write a fixed price contract. P roof. With 7r^=1(s = 0) = r l+ U t (v - P ) + ( 1 - t) {v -c)/(e)cfe + J o r{c2— c + T ) (1 — r) (D + (v — c — 2o-))f(e)de + J(D+I) fO O (1 - r ) (D)f(e)de - d(r, T) J(c2 -c+r) t t a =i (s = 1) = p V — < 7 — C + J t (v — c) + (1 — r) (v — c)f(s)d£ J 0 /•oo /•OO + (1 - t) _ {D)f{e)de — d(r ,T) Jv— a— c+I Since I(s = 1) > I(s = 0), for all D □ v — ” , 7r^=1(s = 1) > 7r^=1(s = 0) 1 A=0 7 r° = t (v — P) + (1 — r) f (v — P)f(e)de + J o /■ (ci-c+ J) (1 — r) J (v — P — s(c — c))f{£)de + roo (1 - r ) _ (D)f(e)de-d(r,T) ■'(ci - ” + /) R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 116 W ith s = 1, the contract never gets renegotiated since c\ = oo. Because of this 7r^=0(s = 1) = r v —a —c + I t ( v — c) + (1 — t ) / (v - c)f(e)d£ + JO /•OO + ( l - r ) / _ (D)f(e)de-d(r,T) J v - c r - ~ + I ^A=oO = 0) = r I + D t ( v - P ) + (1 - t ) / (v - c)f(e)de + J 0 rOO + (1 - t) (D)f(e)de - d(r,T) Jd+i Since I(s = 1) > I(s — 0), for all D □ v — c, 7r^=0(s = 1) > iT\=0(s — 0) ■ This result follows because if the owner has no bargaining power then she is going to write a cost plus contract since with cost plus contract there is no renegotiation. Since almost all contracts are incomplete (as the future costs are impos sible to describe completely ex ante) courts play an important role in the contractual endeavour between the contractor and the owner. The courts basically fill in the in-contractual gaps. This duty they perform by designing damages. As stated earlier if the ex post cost is higher than the value the of R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 117 project then it is efficient for the contractor to breach and pay the damage D. The damage size affects the behavior of the contractor since it affects his outside option during the renegotiation. This damage also has figures in the incentive constraint of the contractor forcing him to breach only if it is efficient. If expectation damages are used then the participation constraint of the contractor is P + s(c — c) — c) = — {v — P — s(c — ”)) Therefore the contractor will try to renegotiate only if the cost is cx > v. And if reliance damages are used then the participation constraint is P + s(c — c) — c) = —(P + s(c — c)) Therefore for costs more than ci, the contractor will want to renegotiate, where 2 (P - sc) Cl~ 1 - 2 s The above analysis has been done with stipulated or liquidated damage affecting the bargaining result. The owner designs a contract with stipulated damages sue that it maximizes the contractor effort. If fixed price contract is R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 118 chosen then the liquidated damage has the characteristics of the expectation damages. P ro p o sitio n 17 With fixed price contracts, s = 0, the investment I made by the contractor is maximized by an optimal damage D* — D(v,~, A , a) such that % > o. $ > 0. a n d ^ □ 0. P roof. J = - lo g ( ^ ) with s = 0, CfLo = I1 - r )(l - e“D) - (1 - r)e~DD - (1 - t) +(1 - r)((l - A)u - D + “A - 2<r(l - A))(e- ^ - 2 < T -“) - e“D) + (1 — r)(2 — A )e~DD — (1 — r)( 2 — A)e- ^ _2cr-c)(v — 2< r — c) + (1 -T )D e -(v- 2a~V dCD - T f f 2 = (1 — r)e~D + (1 — t)((1 — A)u + “A — 2<x(l — A))e~'D dU - h ( l- r ) ( 2 - X)[e~D - e ~ DD] d (jD Prom = 0 we get D dD 1 + ((1 - \)v + cA - 2cr(l - A)) + (2 - A ) (2-A) Therefore D* = D(v,c, A , cr) such that ^ > 0, ^ > 0, and $ □ 0. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 119 P ro p o sitio n 18 With cost plus contracts s = 1, the investment I made by the contractor is not affected by the size of the damage D used in case of breach. P roof. I — - l o g ( ^ ) with s = I, C°= 1 = -(1 - r) + (1 - r)((l -X)v - D + cX - 2<t(1 - X))e^v- ^ ^ -(1 - r)(2 - X)e~(v~2a~™\v - 2a - c) + (1 - = (1 - T)e-t°-2a- ^ - (1 - T)e-(^-^-") = 0 ■ The above propositions characterize hquidated damages when different type contracts are written, namelt fixed price and cost plus. P ro position 19 (i ) For all s and A > 0 expectation damages induce more investment by the contractor than reliance damages. (ii) For all s and A = 0 reliance damages induce more investment by the contractor than expectation damages. Proof. If expectation damages are used then the contractors pay off is given by m a x r(P — c + / ) + ( l — t)[J (P — e —c + I)f{s)de R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 120 r(c2 - “+/) + (P + s(c — c) - c)/(e)cfe r O O + J {C2_ T + I ) ( - ( V - P - s { c - c)))/(e)efe] - a l And if reliance damage is used then the contractors payoff is max r ( P — c + I) + (1 — r)[ [ (P — e — c + I)f(e)de i J o r { c \ - c + I ) + Jj (P + s(c - c ) — c)f(e)de f(C2~C+I) + / ((c P s(c “)) + (1 - A)(w — c - 2<j))f{e)d£ J { c i - ~ + I ) roc + /. _ ( - ( P + s(c- “))/(£)&]- a / */(C 2-C + J) For Vs, A > 0, /(-D=('y ~ -P~5 (c"")) > /P=(-P+5(c-c)) And Vs, A = 0, /P=(«-P-dc-")) D 7(.d=(p+s(c--)) m The main reason for this result is that with expectation damages the contractor does not find it in his interest to try and renegotiate the older contract, while with reliance damages the contractor wants to renegotiate the older contract. And if the contract is not renegotiated and the contractor is able to recuperate all the benefits of his investment. Thus expected damages induce more investment. But if reliance damages are used then this increases R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 121 the possibility of renegotiation and therefore loss of marginal benefit from investment. In the case where the contractor has all the bargaining power then though the contract may get renegotiated and the contractor is able to enjoy the complete benefit from investment. The above two results emphasizes the importance of the bargaining power of the contractor in the ex post stage regarding the type of the contract written and the damage rule the court can use. The bargaining power of the players is influenced by a number of issues, for instance the size of the firm, and the nature and institutional structure of the industry. It is recognized in the construction industry and by the courts that the contractor often moves into a stronger bargaining power as the project starts (pp 445, Sweet (1999)). This bargaining power is countered by the owner’ s dominance over the change process. Not only the is the contractor supposed to act on whatever the he is asked to do but also the owner has control of the purse strings. The judicial resolution of the disputes often do take into account the owner’ s, or the contractor’s, strong position in the case. This is mostly seen in the courts attitude towards the change order mechanism . As seen in Mobil Chemical Co. v Blount Bros Corp, 809 F2d 1175 and Hensel Phelps Constr. Co v King County 787 P2d 58. In these cases the court agreed with the contractor that R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 122 the owners had misused the change mechanism due to their superior power and relieved them of the extra and accelerated work asked by the owner. Also see C. Norman Peterson Co. v Container Corp of America 172 Cat App 3d 628. Therefore if the court realizes that one party has more bargaining power then the damage rule used can be expectation or reliance. 3.5.3 Endogenous A nticipated Cost So far we have formalized the problem such that the owner chooses design of the project. We now formulate the problem so that the owner chooses the anticipated cost of the project. Tirole(86) has discussed the problem that in a procurement contract when the cost is described ex ante it is always underestimated. The contract is often based on the ex ante described cost or the anticipated cost. We show that the owner always chooses the anticipated cost which is less than the expected cost. This leads to higher probability of cost overruns which in turn leads to renegotiation in procurement contracts. In the model discussed so far, if the owner chooses the anticipated cost, he chooses a cost which is always lower than the expected cost of the project. The cost is distributed exponentially /(c) = with an expected cost of c = 1. As earlier we also assume that (3=1. Let the cost of choosing c be R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 123 e: ^ c); so that the cost increases as the described anticipated cost is closer to the expected cost. The expected profit of the owner is max (v — P)f(c)dc + I (v — P — s(c — ~))f(c)dc c Jo J? max c + f {D + \{v — c — 2a) f{c)dc + f (D)f(c)dc — e & c) P ro position 20 If the contract written is such that 0 □ s □ 1, then the anticipated cost chosen is c < c = 1. This result is driven by the cost of describing the anticipated cost. Since describing the anticipated cost rises as the anticipated cost is closer to the expected cost, the owner can never describe the expected cost ex ante. For this reason there is a high probability that the contracts will be renegotiated, since the fixed price aspect of the contract is equal to the anticipated cost. Another reason why the owner chooses to underestimate anticipated cost is that the fixed price part of the contract is based on the anticipated cost. If this is lowered the fixed price will also be lower. There is another effect, i.e., with underestimated anticipated cost there is a higher chance of renegotiation and if the owner has lower bargaining power ex post then he can lose surplus. R eproduced with perm ission of the copyright owner. Furiher reproduction prohibited without perm ission. 124 3.5.4 Im possibility Doctrine Impossibility doctrine works as a defence, for the breaching party. So the impossibility doctrine will relieve the contractor of his obligation to perform if the contractor can show that the realized event makes it commercially impossible to perform. The court allows the breaching party, or in this case the contractor, to use this defence sparingly due to the adverse effect it may have on the incentives. This defence is allowed only if the risk of the unexpected event is not allocated to the contractor. If the risk had been allocated to the contractor then the contractor would have to bear the risk. And this would be specifically true in case of fixed price contracts. According to the law, the allocation of risk does not have to be explicit. Often a test of what is reasonable is used to decide the risk allocation of a future event. The second test which the court uses determines what a contractor in a similar situation would have done. This provides a more objective test for impossibility. The economic explanation for the impossibility theorem is that the impos sibility doctrine provides insurance for the risk averse agent and this increases the social value of the trade. So far in our model we have used risk neutral agents to explain the effect of damages on the incentive of the contractor. In R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 125 case of a risk averse contractor, due to the risk and incentive trade-off, we would expect the optimal damages to be smaller. If the impossibility doc trine was true then the optimal damage would be zero. In this section, with the following proposition we show that the in the model so far described, the impossibility doctrine fails to increase the social value of the trade. P ro p o sitio n 21 If the contractor is risk averse, with a Bernoulli utility function u(x) = e~x, where x is the payoff at the realized state then the optimal damage is D > 0. The reason for this result is that the effort or the investment by the contractor reduces the cost of the project and this benefits the contractor. Therefore the damage not only works as a penalty for the contractor but also induces the contractor to put in more effort in order to reach a low cost state. Though the impossibility of performance is used as a defence for breach (see Hensler v City of Los Angeles (1954) 124 CA2d 71), the mere unforeseen difficulty is not an excuse for default. The above result may explain this. For instance in Kennedy v Reece (1964) 225 CA2d 717, the contractor was not excused from performance when unforeseen conditions increased drilling costs from $3.50 per foot to $5 per foot. The rule which qualifies this defence of damage claim is that whether a similar contractor in a similar state would R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 126 be able to perform the same task. For example in Mineral Park Land Co. v Howard (1916) 172 C 289, the contractor was excused from his obligation to perform after the actual cost to perform increased to 12 times the anticipated cost. Therefore in the above model unless the realized cost is close to infinity the impossible doctrine is not optimal. 3.6 Conclusion In this chapter we have a simple model to explain some of the features of contracting in the construction industry. We have a model of cost overrun which is a common feature of the construction industry. We provide a pos sible explanation why cost overruns occur. Since the projects are complex the contracts written are generally incomplete, and this often leads to cost overruns. We also show that the type of contract written is likely to be fixed price or cost plus. Though fixed price are the preferable contracts they have a high ex ante cost and a high ex post cost for the owner if the owner does not have much ex post bargaining power. Design for fixed price contracts are very expensive, especially if the project is complex, and if the design is not complete and the contract gets renegotiated. In case of renegotiation, the owner is likely to get held up by the contractor because of the contractor’s R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 127 superior bargaining power. In case the design is not complete a cost plus contract does better not only because of the reduced costs of designing, but also because cost plus contracts do not get renegotiated. This prevents any kind of hold-up. This chapter also adds to the damage literature. The high number of contractual disputes in the construction industry means that the damages which are used affect the behavior of the contracting agents. We characterize the optimal damage rule in order to induce the contractor to make the best possible investment. This paper adds complexity of the trade to the damage literature. W ith higher complexity different contractual arrangements are used and for each of these contractual arrangements the optimal damages may be different. We show that damages are determined by the complexity of the project and the bargaining power the players have in the renegotiation game. We are also able to explain why in the construction industry such high number of projects have cost overruns. Due to the transaction cost of writing contracts players often choose to write oontracts which are incomplete. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 128 References Acret, James. (1999) California Construction Contracts and Disputes. California Board of Continuing Legal Education. Berkeley, CA. Anderlini, L. and Felli, L. (1999): “Incomplete Contracts and Com plexity Costs” Theory and Decision. 46,23-50. Ashley, D.B. and Workman, B.W. (1986). Incentives in Construction Contracts. Construction Industry Institute Source Document 8. Ayres, I. and Gertner, R. (1989): “Filling Gaps in Incomplete Con- tracs:An Economic Theory of Default Rules” , Yale Law Journal. 99, 87. Bajari, Patrick and Steven Tedalis (2001): “Incentives versus Trans action Costs: A Theory of Procurement Contracts”, Rand Journal of Economics. 32 , 387-407 Banerjee, Abhijit and Esther Duflo (1999): “Reputation Effects and Limits Of Contracting: A Study Of the Indian Software Industry”, mimeo, MIT. Barnett, R.E. (1999). Contracts: Cases and Doctrines. 2nd Edition. Aspen Law and Business, NewYork, NY. Camerer, C. and M. Weber (1992): “Recent Developments in Unfore seen Contingencies” , Journal of Risk and Uncertainty. 5, 325-370. Che, Yeon-Koo and T.Y. Chung (1999): “Contract Damages and Co operative Investments”, Rand Journal of Economics. 30(1), 84-105. Cooter, R. Marks, S. Mnookin, R. 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(1961): “Risk, Ambiguity and the Savage Axioms”, Quar terly Journal of Economics. 75, 643-669. Epstein, R. (1975): “Unconsdonability: A Critical Reappraisal”, Jour nal of Law and Economics. 18, 293-331. Finkel, Gerald (1997). The Economics of the Construction Industry. M.E. Sharpe. Armonk, NY. Ghirardato, P. and Marinacci, M.(1999): “Ambiguity Made Precise: A Comparative Foundation”, Cal Tech Working Paper. Gilboa,I. and Schmeidler D. (1993): “Updating Ambiguous Beliefs” , Journal of Economic Theory. 59,33-49. Goetz, C. and Scott, R. (1977): “Liquidated Damage Penalties and the Just Compenation Principle: Some Notes on an Enforcement Model of Efficient Breach”, Columbia Law Review. 77, 554. Goetz, C. and Scott, R. (1985): “The Limits of Expanded Choice: An Analysis of the Interactions between Explicit and Implied Contract Terms”, California Law Review. 75, 261. Grout, P.(1984): “Investments and Wages in the Absence of Binding Contracts: A Nash Bargaining Approach”, Econometrica. 52, 449-460 R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 130 Hart, Oliver and B. Holmstrom (1987) “Theory of Contracts” in T.F. Bewley, ed., Advances in Economic Theory: Fifth World Congress. Cambridge University Press, Cambridge. Hart, Oliver and John Moore (1990): “Property Rights and the Nature of the Firms”, Journal of Political Economy. 98, 1119-11158 Hart, O., and Moore, J.(1988): “Incomplete Contracts and Renegotia tions.” , Econometrica. 56 , 755-785. Holden, S. (1999): “Renegotiation and the Efficiency of Investments ”, Rand Journal of Economics. 30, 106-119. Ibbs C. W. et al.(1986): “Determining The Impact of Various Construc tion Contract Types and Clauses on Product Performance: Volumes 1 and 2.” The Construction Industry Institute, Austin Texas. Katz, A. 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Further reproduction prohibited without perm ission. 131 Osborne, M.J. and Rubinstein, A. (1990) Bargaining and Markets. San Diego, Calif.: Academic Press. Posner, R. (1977). Economic Analysis of Law. 2nd Edition. Aspen Law and Business, New York, NY. Rakoff, T.D. (2002): “Symposium: Law, Knowledge and the Academy”, Harvard Law Review. 115,1278. Rogerson, William (1984): “Efficient reliance and Damages Measures for Breach of Contract”, Rand Journal of Economics. 15, 39-53. Rosen, Sherwin (1985): “Implicit Contracts: A Survey ”, Journal of Economic Literature. 23, 1144-75. Schwartz, A. and Watson, J. (2001): ‘ The Law and Economics of Costly Contracting and Recontracting”, Dept, of Economics, Univer sity of California, San Diego Working Paper. Shavell, S. (1984): “The design of Contracts and Remedies for Breach”, Quarterly Journal of Economics. 89, 121-47. Schmeidler, D.(1989): “Subjective Probability and Expected Utility without Additivity”, Econometrica 57, 571-587. Spier, Katherine and Michael Whinston (1995): “On the Efficiency of Privately Stipulated Damages for Breach of Contract: Entry Barriers, Reliance, and Renegotiation”, Rand Journal of Economics. 26, 180-202. Sweet, Justin (1994). Legal Aspects of Architecture, Engineering and the Construction Pocess. West Publishing Comany. St. Paul,MN. Tirole, Jean (1986): “Procurement and Renegotiation”, Journal of Po litical Economy. 94, 235-259. Topkis, Donald (1998). Supermodularity and Complementarity. Prince ton University Press, Princeton, NJ. Rohdenburg, T.K. and Walker, N. (1968). Legal Pitfalls in Architec ture, Engineering, and Building Construction. McGraw-Hill Book Co. New York,NY. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. 132 Williamson, O. (1985). The Economic Institutions of Capitalism. The Free Press, New York,NY. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission.

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Asset Metadata

Creator Chakravarty, Surajeet (author)

Core Title Essays on contracting in the construction industry

School Graduate School

Degree Doctor of Philosophy

Degree Program Economics

Publisher University of Southern California (original), University of Southern California. Libraries (digital)

Tag Economics, Commerce-Business,OAI-PMH Harvest

Language English

Contributor Digitized by ProQuest (provenance)

Advisor MacLeod, W. Bentley (committee chair), Dawid, Herbert (committee member), Talley, Eric (committee member)

Permanent Link (DOI) https://doi.org/10.25549/usctheses-c16-541015

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Rights Chakravarty, Surajeet

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