The Simple Micro - Economics of Public - Private Partnerships January 2009

We build a unified theoretical framework to analyze the main incentive issues in Public Private Partnerships (PPPs) and the shape of optimal contracts in those contexts. We present a basic model of procurement in a multitask environment in which a risk-averse agent chooses unobservable efforts in cost reduction and quality improvement. We begin by studying the effect on incentives and risk transfer of bundling building and operation into a single contract, allowing for different assumptions on the contractual framework and the quality of the information held by the government. We then extend the basic model in several directions. We consider the factors that affect the optimal allocation of demand risk and their implications for the use of user charges and the choice of contract length. We study the relationship between the operator and its financiers and the impact of private finance. We discuss the trade-off between incentive and flexibility in long-term PPP agreements and the dynamics of PPP contracts, including cost overruns. We also consider how the institutional environment, and specifically the risk of regulatory opportunism, affects contract design and incentives. We conclude with some policy implications on the desirability of PPPs. JEL Classification: D8, L5, H54, H57.