PAY-OFF EXTERNALITY AND PERFORMANCE-BASED MAINTENANCE CONTRACTS

Abstract

This paper examines the adverse selection and moral hazard issues in the performance-based contracts for infrastructure maintenance, which are caused by the pay-off externality between the contracts in the different points in time and by the private monitoring made by the agents. The adverse selection and moral hazard can not be deterred by the penalty systems and competitive tendering, if the maintenance works are carried out by a sequence of the separated short-term contracts. On the other hand, the adverse selection and moral hazard can be efficiently deterred by the long-term contracts with a single agent internalizing the pay-off externality, as far as the agent is forbidden to quit from the contract throughout the contract periods. However, the efficiency of the long-term contracts is flawed if the breach of the contract can be made by the agent. The paper also investigates the means to deter the strategic breach by the agent.