Economics of Contracting Public Project

Abstract

Abstract In this paper I consider a politician, an agent to the society, who wants to construct a dam that benefits the society. Due to various reasons such as lack of knowledge or time to construct and coordinate the construction work of the dam, the politician delegate these activities to its employee, a bureaucrat. The bureaucrat her self delegates the construction work of the dam to a contractor. The politician allocates a fixed budget to the bureaucrat so as to maximize the expected values the dam gives to the society. Given the budget, bureaucrat designs an incentive feasible menu of contract to the contractor. The bureaucrat’s contract specifies the quality of the dam constructed and the contingent transfer to the contractor. Satisfying the incentives and participation constraints of the contractor, the bureaucrat maximizes the expected value of the dam and the excess budget. The excess budget to the bureaucrat is the difference between the budget allocated to her and the contingent transfer she makes to the contractor. Bureaucrat values an excess budget by attaching a weight. Bureaucrat attaches larger weight to the excess budget values it more than those attach a lower weight. In order to judge the expected value of the dam under the contract offered by bureaucrat, I choose the standard second best contract as the benchmark. Comparing the contract offered by bureaucrat to the benchmark, I show that bureaucrat offers a contract that provides a better expected value of the dam to the society than the benchmark contract. Even though bureaucrat offers a better contract than the benchmark, the objective she involves in maximizing excess budget creates a problem for the politician and the society. Thus, I show that direct control by the politician can decrease the weight the bureaucrat attaches to the excess budget and provides a better expected value of the dam to the society. I also extend the model to a case in which the Politician’s objective function sets to internalize the pollution cost due to the construction of the dam so as to attain the socially minimum and efficient level of pollution. Assuming that the objective of the bureaucrat is not set in such way that she internalizes the pollution cost arises from the construction of the dam, I show that centralized contract by the politician can solve this difference in objectives between the politician and the bureaucrat and helps the politician to control the bureaucrat.