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.