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The cost of second best pricing and the value of risk premium

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  • Eriksen, Knut Sandberg
  • Jensen, Svenn

Abstract

Private provision of public infrastructure (PPP) is meant to give incentives to increased efficiency in construction as well in operation and maintenance of the infrastructure e.g. within the transport sector. Efficiency is not only (private) economic efficiency, but also social efficiency e.g. social marginal cost pricing of use of the infrastructure. Is it possible to design contracts concerning payment mechanisms and financial instruments for transport infrastructure that will stimulate social efficiency and optimal allocation of risks between parties? The paper discusses whether different targets can be met and whether compromises may lead to acceptable second best solutions. PPP implies an opportunity to let the user-payment give desired incentives in the form of Social Marginal Cost Pricing (SMCP). A PPP project is a set of contracts and agreements between several parties, including the Government, the private contractor, subcontractors, banks and infrastructure users. These contracts should be designed to give the right incentives to the parties to achieve optimal risk allocation and utilising of resources. Long contract-periods are a common feature of PPPs. The paper examines the way that financial solutions should be designed to achieve the goals for the PPP-projects concerning economic and social efficiency. The expected size and variation of the income stream from the project will influence the loan conditions offered by banks concerning interest rates, guarantees and repayment and also the ability to attract investors. The balance between equity and loans again influences the conditions of the loans. An additional problem is asymmetric information between parties. The private contractor usually knows more about the task than the Government (hidden knowledge), and the Government cannot have full knowledge of the efforts of the contractor (hidden actions).

Suggested Citation

  • Eriksen, Knut Sandberg & Jensen, Svenn, 2010. "The cost of second best pricing and the value of risk premium," Research in Transportation Economics, Elsevier, vol. 30(1), pages 29-37.
    • Handle: RePEc:eee:retrec:v:30:y:2010:i:1:p:29-37
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    References listed on IDEAS

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    Cited by:

    1. Batabyal, Amitrajeet A. & Beladi, Hamid, 2015. "Optimal transport provision to a tourist destination: A contract theory perspective," Economic Modelling, Elsevier, vol. 47(C), pages 180-184.
    2. Jin, Hongyu & Liu, Shijing & Sun, Jide & Liu, Chunlu, 2021. "Determining concession periods and minimum revenue guarantees in public-private-partnership agreements," European Journal of Operational Research, Elsevier, vol. 291(2), pages 512-524.

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