Double Moral Hazard and Risk-Sharing in Construction Projects

Construction projects are riddled with risks that should be shared by both owners and contractors alike. The principal-agent theory has proven to be an influential theoretical apparatus in designing optimal risk-sharing rules and provides contractors with proper incentives to improve project efficiencies. According to the principal-agent theory, it is optimal to let the contractor assume all of the risk if it is risk-neutral. However, this article argues that this theoretical model may lead to a biased incentive structure. To demonstrate this point, this article analyzes the necessity of risk-sharing between the owner and risk-neutral contractor in construction projects. Taking into account cases where the respective planning efforts of the owner and contractor are supposed to be unverifiable and mutually complementary in terms of cost overrun risk, we find that either double moral hazard (i.e., both parties take opportunistic strategies) or inefficient breach of contract by the contractor occurs if the contractor assumes the entire cost overrun risk. An optimal risk-sharing strategy, therefore, plays an important role in coordinating both parties to choose efficient strategies.