The Cost of contract renegotiation: evidence from the local public sector

Abstract

We construct and estimate a structural principal/agent model of contract renegotiation in the French urban transport sector in a context where operators are privately informed on their innate costs (adverse selection) and can exert cost-reducing managerial effort (moral hazard). This model captures two important features of the industry. First, only two types of contracts are used in practice by local public authorities to regulate the service: cost-plus and fixedprice contracts with positive subsidies. Second, these subsidies increase over time. Such increasing subsidies are consistent with the theoretical hypothesis that principals cannot commit not to renegotiate and contracts are renegotiationproof. We compare this situation to the hypothetical case with full commitment. The distribution of innate costs of operators is shifted upwards under this hypothetical scenario. The welfare gains of commitment are significant and accrue mostly to operators. Estimates of the weights that local governments give to the operator´s profit in their objective functions and of the social value of the cost-reducing managerial effort are obtained as by-products.