Constructing Costs
The economic analysis of building contracts is an unexplored field within Law and Economics. This paper makes an attempt to cast some light over the subject and encourage to more research within the field. The main purpose has been to describe why the actual price in a public construction project often turns out to be higher than the contract price and offer a way of handle that risk. In the paper a model is set up that shows an optimal contract given expectations on actual price and gaps in contracts. Cost increases for the buyer can mainly be explained by two situations. The first situation is when something unexpected occurs that forces costs to increase for the project as a whole and the risk is already allocated in advance. If the contract specifies that the buyer should bear the current risk it will not cause any procedural problems and the project will end up more expensive for the buyer. The second situation arises when a risk is realised and the contract has not specified how to deal with it. Bargaining power and anticipations on the other parts behaviour will be of significance for how to place the extra costs. A more general discussion is also held about contract forms in the construction sector and the way that different contracts handle financial risk. One conclusion is that a fixed price contract without any gaps probably is the best way for the government to keep control of cost increases. Unfortunately, in the real world almost all contracts suffer from gaps. The paper concludes that cost plus contracts should be used very rarely mainly because of the low incentives it gives the contractor to keep costs down.