Paying for performance: Uncertainty, asymmetric information and the payment model

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Abstract

Privatisation has led to a growing interest in more complex contractual forms designed to give public transport operators the incentives for effort that maximise value for money. Contract theory provides a rich research basis for selecting an appropriate contractual form, with an emphasis on the effects of uncertainty and asymmetric information. To date, however, there have been few applications of contract theory in the field of transport. This paper identifies the key empirical results from the multi-disciplinary literature to help transport researchers and practitioners place contractual decision-making in the broader theoretical context, suggesting aspects of transport contracting that merit future research.

Introduction

Interest in optimal contracts has grown in recent years as governments look for new ways to maximise value for money in the provision of transport services. While debate continues about choice of mechanism (for example, negotiated contracts or competitive tender) to procure these services (see Hensher & Wallis, 2006 for discussion of this important issue), this paper abstracts from this debate to examine another tactical element of the STO framework1 (see Macario, 2001, van de Velde, 1999): the payment model.

Consider two parties, a principal (say, a regulator) and an agent (an operator) who have chosen to do business together. What type of payment model should the regulator offer? Wallis (2003) defines and describes the range of payment models that are commonly applied in the urban public transport sector (summarised in Table 1), including performance-based contracts (PBCs). The optimal use of PBCs in public transport has been the focus of some important research in recent years (e.g. Fearnley et al., 2005, Hensher and Houghton, 2004, Hensher and Houghton, 2005, Hensher and Stanley, 2003).

The choice of an optimal payment model is more complex than it may at first appear; it is specific to the situation at hand, and in most cases involves complex trade-offs. A rich body of theoretical and empirical literature, broadly known as contract theory, can help us make optimal, or at least informed, payment model decisions.

The paper is divided in two parts. In Section 2, the key tenets of contract theory are briefly sketched, giving us some basic tools for analysis of the ‘real life’ contracts observed in public transport. Section 3 turns to the application of the theory in transport and other contexts, examining how well theory predicts the contractual forms that we actually observe. Section 4 concludes the paper with some suggestions for future research.

Section snippets

Contract theory

The term contract theory generally refers to ideas about incentives, information and economic institutions. These ideas transcend disciplinary boundaries, finding particular relevance in economics, finance, management and corporate law. Contract theory began with the classic ‘Edgeworth box’, extended in the 1950s to explicitly consider situations involving uncertainty. In the 1970s, contractual situations involving asymmetric (or hidden) information were introduced, leading to a rich theory of

Applying the theory

As Chiappori and Salanie (2003) demonstrate, empirical validation of contract theory has long lagged behind the theoretical work. They show that empirical contributions should be examined carefully as unobserved heterogeneity is rarely controlled for adequately in this literature, and the resulting combination of unobserved heterogeneity and endogenous matching of agents to contracts creates selection bias in the parameters of interest.

The difficulty lies in the fact that, although risk

Conclusions

Selecting the optimal payment model involves complex trade-offs and is specific to the contracting situation. In the process of briefly sketching the extensive theoretical and empirical developments in contract theory, some general principals have emerged to guide payment model choice in the transportation context, but what is really needed is careful, empirical research to test the theory in the transport setting. Identification of the risk preferences of contracting agents would be an

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