Incentives in Engineering Contracts: A Critical Review of the Principle of Optimal Risk Sharing

Incentive is widely used in engineering contracts to elicit the contractor's best efforts in hope of reducing construction cost. The intensity of incentive is normally determined in accordance with the principle of optimal risk sharing from the Principal-Agent theory. As evidenced by the ongoing financial crisis, this doctrine may lead to overuse of incentive and bring about systemic risk. This crisis has exposed a fundamental flaw in this mainstream theory that the contract breakup cost is exceedingly higher than that already accounted for. This research sets out a numerical example in the context of project procurement to make a case for the necessity of redressing this pitfall and calls for a new line of thinking that can fully accommodate the risk-bearing capacity of a contract into the design of contract.