Optimal Contracts of Public-Private Partnerships with Demand Risk

Abstract

The paper analyzes the service provision of infrastructure from the

aspect of demand risk sharing. The society benefits more under the

public-private partnership (PPP) than under government operation,

because the government can transfer some risks to private firms

through PPP. To reduce total cost, the government is more likely to

apply PPP to projects with large risk factors. Using a two-period model,

the paper examines the dynamic features of the optimal contract under

the PPP. The optimal incentive scheme should be stronger during

the second than the first period. As the performance target becomes

lower, the incentive power increases in both periods with a higher

increase in the first period. As the intertemporal externality becomes

stronger, the incentive power increases in both periods with a higher

increase in the second period. As the risk or risk aversion increases,

the incentive power decreases in both periods, which resembles the

static feature.