The Design of Asymmetric Information Contracts for Public Sector Projects with Private Sector Participation

Over the last few years, multilateral lending institutions and governments have expressed increasing concern over the accumulation of contingent liabilities and their role in aggravating fiscal and financial fragility in developing economies. The accumulation of these contigent liabilities, brought about mostly by the provision of government gurarantees, has prompted researchers to more closely scrutinize government contracts, specifically contracts for the provision of infrastructure goods and services in projects where there is private sector participation. The problem with these contracts seems to stem from adverse selection. Because of the adverse selection problem, contracts negotiated by government with private investors do not seem to be designed in a manner that achieves an optimal sharing of risk. As a result, the government is saddled with financial claims: investors seeking compensation for risks assumed by government. This study uses a simple model to solve for the optimal contracts under a situation where the government has asymmetric information about the quality of inverstors in essesntial infrastructure goods and services. The analysis concludes that it is possible for the government to offer a set of incentive-compatible contracts to investors. The terms in these contracts cover three variables: quantity, price/tariff and the level of guarantee coverage. In the set of optimal contracts, these three variables are endogenous variables.