Contracts are a bilateral incentive problem, where opportunities for information exchange and strategic interaction exist.
Contracting becomes worthwhile when there is a temporal element to exchange or one party is unsure about what a counterparty will do.
When contracts are used for coordination they are self-enforcing, in the sense that it is in each party’s interest ex post to comply. In this case the focus is on problems of contract design.
• This works for labour contracts and regulation, for example.
When using contracts to implement exchanges that depend on future events a commitment mechanism is required. In this case the focus is on incentives and the principle-agent problem.
In an ideal world it is possible to write a complete contract that induces the both principals and agents to take the `right' actions in every possible state of world.
• This leads ex post to a Pareto efficient outcome.
Contract theory studies the form of contracts in less than ideal worlds, where there exists:
• Hidden action (or moral hazard): when one party's behaviour cannot be perfectly
monitored by others.
• Hidden information (or adverse selection): when one party has private
information not known to others.
• Contractual incompleteness: when contracts do not deal with all relevant
Incomplete contracts and costs
It is costly to specify all potential contingencies that might be relevant to the performance of the parties’ contractual obligations, so contracts are left incomplete. Incompleteness has (at least) two meanings:
1. The contract could not provide for certain contingencies.
2. The contract could cover all contingencies, but not distinguish among them.
Therefore the contract will not assure commitment, and the parties will follow a course of action that is suboptimal ex post.
Monitoring and enforcement costs. It is never costless to hold an agent to their commitments, particularly when lawyers get involved, and half of all commercial litigation is about construction contracts and disputes.
Even if legal commitment has been established and the means for its enforcement are available, the beneficiary of a contractual promise may be unable to determine whether the promise has been kept or broken. Some, possibly many, actions are unobservable and/or unverifiable.
Contracts are useful in situations of hidden information. For example, in Akerlof’s lemons model adverse selection can prevent efficient exchange when quality is known to the seller but not to the buyer. Here, the seller can signal quality by taking an action such as offering a warranty against substandard performance. The ratchet effect is another example, where the agent restricts performance in period 1 to lower the principal’s expectations of future performance or effort in period 2.
2016 Nobel Prize in Economics
Holmström and incentives
Bengt Holmström’s research focused on the optimal design of contracts from the perspective of an employer and their arrangements with a worker. This is a classic principal-agent problem, and the issue is designing the best contract since there are competing incentives. He and his co-authors addressed a range of issues.
In ‘Moral Hazard and Observability’(1979) he proved what is known as the ‘informativeness principle’, an optimal contract must include every possible factor that conveys meaningful information about the employee’s effort.
Contracts have been the focus in construction industry policy, where the emphasis has been on contractual relations and the supply chain.
Hart and control rights
Oliver Hart, in the 1980s, made fundamental contributions to the new branch of contract theory on incomplete contracts. Because contracts cannot specify every eventuality, he focused on the optimal allocation of control rights: which party to the contract should be entitled to make decisions in which circumstances?
Organizational arrangements such as allocation of ownership rights, authority or financial control are central. These are essentially property rights and in the property-rights models of Hart and his co-authors, decision rights over physical assets are the crucial source of bargaining power and incentives.
Hart’s theory is especially relevant to analysing strategic alliances, the terms of trade between partners, and the complex relationships between contracting and the market.
Information and transparency
What insights can contract theory and incomplete contracts provide when applied to construction contracts and the issues of:
1. Moral hazard and hidden action.
2. Adverse selection and hidden information.
3. Incompleteness and property rights.
In each case the client/principal has limited or no access to relevant information.
This suggests many of the academic publications on BIM are at best misguided, because they typically treat the contractor as the principal. They also do not demonstrate much understanding of the history of technology.
Transparency through technology
It is difficult to observe technological change in a project based industry.
Evidence tends to be anecdotal, say Skanska’s Flying Factories, rather than systemic, like BMW’s carbon fibre manufacturing.
Thus most construction and architectural histories are a series of case studies of significant buildings (e.g. Crystal Palace) or projects (e.g. Panama Canal).
If institutions and organisational processes can be taken as proxies for underlying trends in technology they can be used.
Examples of emerging technology
Trimble Connect – launched December 2016 by the maker of Prolog. The market leader in GPS, now collaborating with Microsoft to use the Hololens with the aim of “transforming how architects, engineers, contractors and owners work”. The Daqrismart helmet uses Hololens.
SAP Connected Construction – uses IoT to link site activities to PM and plans. Launched 2015.
Nearmap and Sky and Space – GIS based systems that allow site progress to be viewed.
3D Repo developed at UCL by Jozef Dobosin collaboration with Balfour Beatty and industry organisation Finishes and Interiors Sector, it allows main contractors to manage and digitally distribute project proposals. The Bid4Free solution is based on the 3D Repo framework as an open source web-based system that provides a free online tendering platform. Contractors can post their BIM projects for subcontractors to exchange RFIs and place bids.
Their cloud-based platform enables collaboration across the lifecycle of building projects. It supports document management, cost management, bid and tender processes, workflow management, field management, and asset handover. It fully integrates BIM and design development. Contract admin is being added in 2017.
Originally a project management system, like many others started in the dot com era, with contractors as the market. In 2016 moved to a new model.
The project owner signs up for access to the Aconex collaboration platform. The owner is the fee-paying customer —a ‘subscriber’ in Aconex’s book. Other non-fee paying users, the project’s consultants, contractors and suppliers, obtain access to the platform through the fee-paying account holder.
The offer …. is transparency
Get the visibility you need to spot problems and control risks that can lead to delays and cost overruns. Receive high-quality handover manuals that are compiled digitally, as-built, and as the work is completed.
Get the information you need to coordinate processes between project managers, consultants, subcontractors and your client. Powerful reports and insight tools show you the status of bids, submittals, RFIs, etc.
Report on progress across complex projects involving many independent parties. Provide subcontractors and trades with accurate, up-to-date information and minimize delays and disputes thanks to a permanent archive and an iron-clad audit trail.
Drones and site monitoring
In 2015 a University of Illinois used drones to record the construction of the Sacramento Kings' stadium in California.
The captured images and videos are used to create an 3D model of the site under construction. The system compares this automatically generated 3D model to the as-designed 4D (3D plus time) Building Information Model, resulting in progress monitoring information.
The progress and activity monitoring results are visualized in a cloud-based 4D augmented reality (D4AR) environment. These D4AR models can also be made available through smartphones and tablets.
A 2014 start-up, founded to build drones for project data collection by flying over the works to capture real-time information about their progress, prevent mistakes and detect unsafe situations. The data collected is stored in a cloud and viewed on-site using handheld and desktop computers using the Skycatch dashboard.
Skycatch UAVs scan job sites to capture imagery and automatically generate accurate 3D site data.
Komatsu partnered with Skycatch in their Smart Construction initiative, which uses the drones capture imagery and automatically generate accurate 3D site data, which is compared with 3D drawings of the site to automatically calculate the area and volume of earth to be moved.
Once the data is captured and transferred to the cloud, these systems can automatically detect and track materials, workers and equipment in real-time from the video feeds and automatically categorise activities.
Reconciling visual images with BIM requires machine intelligence. The people involved in these projects have backgrounds in IT, AI and robotics.
Real-time project monitoring has many implications for clients, contractors, suppliers and workers. One can expect many variations in how they play out in different countries and across projects.
Incentives and information redux
How will increased transparency of project and contractor performance affect the industry? Markets run on information, and industry structure reflects information flow and availability.
Monitoring is easier and cheaper, so hidden action becomes more unlikely, decreasing moral hazard and increasing trust.
Owner access means hidden information is decreased, avoiding adverse selection, and contractual commitment increases.
Incompleteness becomes less of an issue and control/property rights more important, for clients who want to exercise them.
Other emerging technologies such as 3D printing, automated prefabrication, high performance materials and new construction chemicals will complement and reinforce structural change in the building and construction industry.
Small firms doing simple work and R&M will continue to do business as usual.
Medium sized firms doing standardised projects will upgrade gradually.
Larger firms delivering complicated and complex projects can be expected to generally benefit more from disruption. Frontier firms will gain the most.