Economic Modelling 102 (2021) 105586

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Economic Modelling
journal homepage: www.journals.elsevier.com/economic-modelling

Excess returns in Public-Private Partnerships: Do governments pay too

much?
Marco Buso a,b,c, ∗ , Michele Moretto d , Dimitrios Zormpas e
a
Department of Economics and Finance, Catholic University of Sacred Heart, Via Necchi 5, 20123, Milan, Italy
b
Interuniversity Research Centre on Local and Regional Finance (CIFREL), Milano, Italy
c Interuniversity Centre for Public Economics (CRIEP), Padova, Italy
d
Department of Economics and Management, University of Padova, Via del Santo 33, 35123, Padova, Italy
e CY Cergy Paris Université, CY Advanced Studies and ESSEC Business School, F-95000, Cergy-Pontoise, France

A R T I C L E I N F O A B S T R A C T

JEL classification: We study the optimal design of Public-Private Partnerships (PPPs) when there is unobservable action on the
D81 private party’s side. We show that if the private party does not have negotiating power over the project’s surplus,
D82 then no inefficient delays are attributable to the moral hazard issue. However, if the private party has negotiating
D86
power, then the first-best timing is not guaranteed. The time discrepancy is shown to be costly in terms of overall
H54
project efficiency. The explicit consideration of the private party’s negotiating power can explain empirical
evidence that private parties in PPPs tend to reap excess returns. These results are discussed in light of the
Keywords: COVID-19 pandemic and its implications for PPPs.
Public projects
Public-private partnerships
Moral hazard
Real options
Investment timing
COVID-19

1. Introduction
The provision of public services frequently implies a contractual
or market relationship between the public and private sector (Quig-
gin, 2005). Public-Private Partnerships (PPPs), an internationally estab-
lished form of such relationships, are agreements between a public
party and a private party regarding the delivery of a public service.
PPPs are adopted in many sectors including transportation, resource
management and healthcare (Engel et al., 2014; de Vrueh et al., 2019;
EPEC, 2019).
While PPPs are perceived as a mainstream form of concession agree-
ments, their design remains challenging because of their distinguishing
features (Dewatripont and Legros, 2005; Engel et al., 2013). PPPs last
for a long time, they have varying degrees of complexity, involve costly
and irreversible investments undertaken by the private sector, and start
generating an uncertain public benefit flow and an uncertain cash flow
as soon as the relevant project becomes operational. Another issue often
detected in PPPs has to do with agency conflicts that can arise between
the public party and the private party. For instance, the private party
often possesses a certain expertise that can be the source of information
asymmetries. Similarly, there may be moral hazard issues attributed to
unobservable action by the private party (Martimort and Pouyet, 2008;
Iossa and Martimort, 2015).
Given these aspects of PPPs, discussion regarding their performance
has been ongoing. Iossa and Martimort (2015) and Martimort and
Straub (2016) show that well designed PPPs may increase efficiency
in public service delivery and budget management. However, they can
become too costly in the presence of high levels of uncertainty or when
the projects are highly sophisticated. Using French data Saussier and
Tran (2012) find that although PPPs are particularly effective in reduc-
ing cost and time overruns, they can be too costly when the remuner-
ation the public party pays to the private party is properly taken into
account. Focusing on the cost of PPPs, Gao et al. (2017) and Hellowell
and Vecchi (2018) find that private parties claim return rates signifi-

∗ Corresponding author. Department of Economics and Finance, Catholic University of Sacred Heart, Via Necchi 5, 20123, Milan, Italy.
E-mail addresses: marco.buso@unicatt.it (M. Buso), michele.moretto@unipd.it (M. Moretto), dimitrios.zormpas@cyu.fr (D. Zormpas).

https://doi.org/10.1016/j.econmod.2021.105586
Received 30 March 2020; Received in revised form 23 June 2021; Accepted 23 June 2021
Available online 2 July 2021
0264-9993/© 2021 Elsevier B.V. All rights reserved.
M. Buso, M. Moretto and D. Zormpas
cantly higher than those on corporate portfolios or other equity assets.
According to Whitfield (2017), although a PPP’s average rate of return
for the private party is approximately 12%–15%, the PPP’s sharehold-
ers often sell their shares for much more. In the same vein, Hellowell
and Vecchi (2013) assess the expected returns on a sample of 77 con-
tracts signed by healthcare provider organizations in the United King-
dom between 1997 and 2011. They show that the difference between
the return rates of private equity investors and the expected return rates
on investments in PPP equity is 9.5%, indicating a high degree of rent
extraction by private investors.
Although extensive empirical literature provides evidence regard-
ing the high private return rates observed in PPPs, to the best of our
knowledge this phenomenon has not been justified theoretically in a
rigorous way. While incomplete contracts are usually seen as the most
prominent weakness of PPPs (Dewatripont and Legros, 2005; Iossa and
Martimort, 2015; and references therein), we show that, even with com-
plete contracts, excess returns are possible. The model that we use to
reach this conclusion considers a public party that is contemplating
engaging in a PPP with a private party. We assume an agency conflict
between the partners such that the private party can increase the prob-
ability of delivering a high-quality project by exerting effort, but the
public party cannot observe whether such effort is actually exerted. In
order to capture some of the stylized facts of PPPs (e.g., sunk investment
costs, uncertain future cash flows, and temporal flexibility for the public
party), we develop a real options model (Dixit and Pindyck, 1994).
By adopting the framework proposed by Grenadier and Wang
(2005), we show that the public party can design a mechanism and
resolve the moral hazard issue. The mechanism proves to be sensitive
to the private party’s ability to influence the contract terms that the
public party proposes. In line with the literature that attributes some
negotiating power to the private party, we use an ex-post participa-
tion constraint that guarantees a non-negative payoff for the private
party. A slack participation constraint corresponds to a private partner
with negotiating power as such private partners are willing to engage
in the partnership only if a strictly positive net present value (NPV) at
the time of the investment is guaranteed. Conversely, a binding partic-
ipation constraint corresponds to a private party without negotiating
power who participates in the PPP receiving the bare minimum, that is,
a NPV that is equal to 0 at the time of the investment.
In this setting we show that if the private party does not have nego-
tiating power, then the first-best timing is guaranteed, the project’s sur-
plus is shared between the two parties, and there are no detrimental
effects on the project efficiency. However, if the private party has nego-
tiating power, then the optimal investment threshold is not guaranteed,
the private party obtains a higher rate of return and there is a cost
in terms of project efficiency. Therefore, high return rates should be
viewed, at least in some cases, as equilibrium phenomena.
Our main contribution lies in showing that the private party’s nego-
tiating power is reflected in high own return rates and is detrimental
in terms of project efficiency. Compared to static moral hazard mod-
els that do not account for choices of investment timing, the private
party’s negotiating power not only causes a transfer of surplus from the
principal to the agent, but also a reduction in project efficiency.
The COVID-19 pandemic has placed national healthcare systems
around the world under significant stress, and has accentuated the
benefit of effective public policies and strong social safety nets. Gov-
ernments use PPPs to leverage scarce public resources and boost pri-
vate incentives in order to invest in high-priority areas such as digital
connectivity, healthcare, welfare, pandemic-proofing of public services,
2
Economic Modelling 102 (2021) 105586
and infrastructure.1 This trend is expected to continue because govern-
ments need to prioritize infrastructure spending in order to boost eco-
nomic recovery and prepare for a potential new wave of the pandemic.
Further, the crisis will most likely lead to large fiscal deficits, making
cooperation between the public and private sector more indispensable
than ever (Fakhoury, 2020). While the public sector’s intention to use
private financing through PPPs to mitigate the challenges of the pan-
demic seems reasonable, the private sector’s ability and willingness to
engage in risky long term projects is questionable. Given the severe
initial socioeconomic impact of the pandemic and the troubled global
economic environment, private firms that would otherwise be inter-
ested in PPPs are expected to approach these partnerships with skep-
ticism, as they will be reluctant (or even unable) to commit to long-
term contracts or to come up with the required financing. The fiscal
cost of the pandemic will necessarily change the private investors’ and
financiers’ attitudes about risk (Knight, 2020). Moreover, firms nego-
tiating their participation in PPPs are expected to ask for preferential
treatment in view of the pandemic and under the pretext that their
activity is essential to the common good. Although the fiscal positions
of the public and private sectors have deteriorated because of the pan-
demic, infrastructure related needs have not done so. Thus, future PPPs
will be arrangements between the public sector (in a weak negotiating
position) pursuing a collaboration with private-sector partners that will
be more cautious than they were before the pandemic. Our work sheds
light on this interplay and its effects on PPPs’ timing and efficiency.
This work contributes to two strands of literature. First, an estab-
lished body of research uses concepts from mechanism design and con-
tract theory to discuss PPPs. For instance, Martimort and Pouyet (2008),
Iossa and Martimort (2012) and Hoppe and Schmitz (2013) focus on
information asymmetries, Hart (2003) and Iossa and Martimort (2015)
discuss task bundling, and de Bettignies and Ross (2009) analyze con-
tract incompleteness. Second, a growing body of papers studies PPP
projects with an emphasis on their real-option-like characteristics (e.g.,
see Alonso-Conde et al., 2007; Brandao and Saraiva, 2008; Martins et
al., 2015; Blank et al., 2016). Some scholars link these two strands (e.g.,
Takashima et al., 2010; Soumare and Lai, 2016; Buso et al., 2021;
Silaghi and Sarkar, 2021). What distinguishes our work from these
papers is that we present a real options model that accounts for both
agency conflicts and a private partner with negotiating power.
The remainder of the paper is organized as follows. Section 2
presents the setup of the model. Section 3 describes the first-best solu-
tion and the principal-agent setting. Section 4 derives and discusses
the optimal contracts for agents with and without negotiating power.
Section 5 highlights the effect that the agent’s negotiating power has on
return rates. Section 6 presents the conclusion.
2. The model
A public authority (principal/she) holds the option to develop a pub-
lic service, which requires an investment of cost I. The principal dele-
gates the exercise of the investment option and the operation of the
related project to a private firm (agent/he) via a PPP. We assume that
1
For instance, in February 2020 the European Union (EU) announced a €
90 million aid package through the Innovative Medicines Initiative, a part-
nership between the EU and the pharmaceutical industry that is dedicated to
urgently needed research regarding diagnostics, therapeutics and prevention
(EC, 2020). In March 2020, the United States (US) government, academia, and
industry formed a PPP to provide COVID-19 researchers with access to high-
performance computing resources (COVID-19 HPC Consortium, 2020). In April
2020 the Australian government partnered with the private health sector to
secure more hospital beds and staff (Australian Department of Health, 2020),
while the Indian government launched Aarogya Setu, a digital service created
to protect its citizens during the pandemic. The service was built through a PPP
(Indian Ministry of Electronics and Information Technology, 2020).
M. Buso, M. Moretto and D. Zormpas
both parties are risk-neutral, the investment can be carried out instan-
taneously, and that it has an infinite life.2
To lay the groundwork for our analysis, this section specifies the
private and public benefit flows generated by the project, the payoffs of
the two partners and the strategic interaction that governs their part-
nership.
2.1. Cash flow and public benefit flow
The PPP generates two sources of value, the cash flow and the public
benefit flow. The former is denoted by xt ∈ (0, ∞) and it is assumed
to fluctuate over time following a geometric Brownian motion (gBm)
with risk-neutral rate of drift equal to 𝜇 and positive constant volatility
equal to 𝜎 :
dxt
= 𝜇 dt + 𝜎 dzt
xt
where x0 = x is the value of the cash flow at time zero and dzt is
the increment of a standard Wiener process that satisfies the condi-
tions E(dzt ) = 0, E(dz2t ) = dt. The realizations of xt are, by assumption,
observable and contractible.3 The use of the gBm is common in invest-
ment theory and is solidly supported by empirical evidence (e.g., Dong,
2013). Its use is also common in analyses of PPP projects. For instance,
for toll road projects, many authors model revenues or the level of traf-
fic as a gBm (e.g., Rose, 1998; Wooldridge et al., 2002; Irwin, 2003,
2007; Huang and Chou, 2006). With regard to airports, Pereira et al.
(2007) assume that the number of passengers and the net cash flow per
passenger are stochastic, following a gBm (see also Xiao et al., 2017).
Similar assumptions can be found in works that analyze real estate (e.g.,
Mao and He, 2009; Durica et al., 2018) and sewage treatment projects
(e.g., Liu et al., 2019).
For the problem that we study to be economically meaningful, we
assume that the risk-neutral rate of drift, 𝜇, is smaller than the risk-free
interest rate, r (Dixit and Pindyck, 1994, p. 138). Accordingly, there is a
positive shortfall in the rate of return, 𝛿 = r − 𝜇 > 0. Thus, the project
generates a rate of cash flows, 𝛿 xt , either as dividends or as liabilities
to the stakeholders, equivalent to the rate of return that a potential
investor can obtain from projects with comparable risk profiles. Eq. (1)
is based on the hypothesis that the project’s systematic risk, (i.e., the
market risk) is separated from the specific risks of the project, (i.e., the
part of the risk that is not correlated to the market). While the former
is remunerated by the market at rate 𝛿 , specific risks can be reduced to
zero through an adequately diversified investment portfolio. However,
when such a portfolio cannot be constructed, standard theory suggests
that specific risks may require an “extra” premium (Hirshleifer, 1988).
Concerning systematic risks, Hellowell and Vecchi (2018) argue that, as
2
The partnership’s duration can be approximated as infinitely long because
PPPs are commonly associated with long concession periods (e.g., Song et al.,
2013). Hence, benefits that occur on a distant future date have little weight in
present terms. ( )
𝜎2
3
Eq. (1) is satisfied by xt = x exp (r − 𝛿 − 2
)t + 𝜎 zt . Thus, the cash flow
at time t depends only on the initial value x and the contemporaneous market
shock, zt ∼ N(0, t). x can be viewed as the estimate provided by an indepen-
dent expert who draws up a business plan. If both parties agree on x (i.e. it is
a publicly observable piece of information), then at each time point they can
infer the value of xt by simply observing the realization of the market shock.
While the assumption of information symmetry regarding xt is often justifiable,
adverse selection in PPPs has attracted considerable interest (Iossa and Mar-
timort, 2012; Hoppe and Schmitz, 2013; Buso et al., 2021). The agent might
have more information about xt and attempt to benefit from it. The presence of
both moral hazard and adverse selection implies changes in the menu of con-
tracts (Grenadier and Wang, 2005). However, as long as the agent’s negotiating
power (defined at the end of this section) remains unaffected by this informa-
tion advantage, considering adverse selection on top of moral hazard would
leave our findings qualitatively unchanged.
Economic Modelling 102 (2021) 105586
investors in the PPP market are not well diversified, they retain many
market-related risks that can be related to fluctuations in demand, infla-
tion, currency exchange rates, availability of funds to sub-contractors,
etc. However, as these risks are systematic, they should be captured in
the market rate. Conversely, concerning specific risks, Merton (1987)
shows that when the markets are segmented and investors have small
or concentrated portfolios, an additional premium for specific risks may
be required.
The second source of value that the PPP generates is a flow of public
benefits, b. For example, in the case of a highway, b captures the bene-
fits of reduced cost and time for transporting commodities, reduced con-
gestion and air, light, and sound pollution in city centers, and increased
road safety. In the case of green public transportation, lower levels of
air pollution are associated with improved air quality and gains for tax-
payers, who save on environmental taxes. Additionally, regarding the
(1) COVID-19 pandemic, efforts toward the preparation for a new wave of
the pandemic benefit the entire population, not just those who have
contracted the virus.4
b is assumed to be an increasing function of a random variable, 𝜃 ,
with possible realizations 𝜃 1 and 𝜃 2 , where 𝜃 1 > 𝜃 2 and Δ𝜃 = 𝜃 1 −
𝜃 2 > 0. A draw of 𝜃 1 can be interpreted as a “high-quality” project,
whereas a draw of 𝜃 2 as a “low-quality” one (b (𝜃1 ) > b (𝜃2 ) > 0).5
While the realization of 𝜃 is not determined by the actions of the two
parties, its distribution depends on the effort level chosen by the agent.6
When effort is exerted, the probability of drawing a high-quality project
𝜃 1 is qH ∈ (0, 1). Otherwise, it is qL ∈ (0, qH ) where Δq = qH − qL .
When exerting effort the private firm incurs a cost 𝜉 > 0.
2.2. The payoffs
As is standard in most PPPs, the agent is assumed to bear responsibil-
ity for building and operating the project throughout its life, to collect
the cash flow generated by the project, and to be protected by limited
liability. As for the principal, she is assumed to benefit from the flow of
public benefit generated by the project. Additionally, as it is common
for the public party to offer an up-front lump sum transfer to help cover
the initial investment cost (Iossa and Martimort, 2012), we assume that
the principal offers a transfer w ≥ 0 to the agent.7 Thus, the agent’s
investment cost is I − w.
With 𝜏 > 0 denoting the time of the investment, and given the
properties of Eq. (1), the agent’s NPV at the time of the investment is:
[ ∞ ]
x
F (x𝜏 , w) = E𝜏 xt e−r (t −𝜏) dt − (I − w) = 𝜏 + w − I (2)
∫𝜏 𝛿
whereas for the principal we have8 :
[ ∞ ]
b (𝜃)
Y (w) = E𝜏 b (𝜃) e−r (t −𝜏) dt − w = −w (3)
∫𝜏 r
4
For expositional simplicity we consider the flow of public benefits net of the
benefits enjoyed by direct users.
5
In many real-world cases, the public benefit flow evolves over time. How-
ever, as long as the process that governs this flow is public information, we can
generalize our model to allow for this.
6
In PPPs, the private party is in charge of designing the project (Martimort
and Pouyet, 2008; Iossa and Martimort, 2015), which affects the public benefit
flow (de Bettignies and Ross, 2009).
7
The transfer w ≥ 0 can capture various payment structures. When w = 0,
we have a user-pay contract exclusively funded by the project’s users. When
w > 0 instead, the contract accounts for availability payments, that is, gov-
ernment subsidies that are contingent on the availability of the realized project
(EPEC, 2018; Engel et al., 2014).
8
Eq. (3) follows Fubini’s theorem that allows interchanging the expec-
tation
[ operator with ] the integral (Harrison, 2014, p.178 Theorem A.5):
∞ ∞
E𝜏 xt e−r(t −𝜏) dt = E𝜏 (xt )e−r(t −𝜏) dt
∫𝜏 ∫𝜏
∞
x𝜏
= x𝜏 e𝜇(t −𝜏) e−r(t −𝜏) dt =
∫𝜏 𝛿
3
M. Buso, M. Moretto and D. Zormpas
Fig. 1. The timing of the game (solid line corresponds to t = 0 and the dashed line to t > 0).
where x𝜏 is the level of the cash flow at 𝜏 .
In contrast to b (𝜃), xt and I are assumed to be unaffected by 𝜃 . This
assumption guarantees perfect asymmetry of the objectives between the
principal and the agent, as the latter has nothing to gain by exerting
effort (e.g., Martimort and Pouyet, 2008; Schmitz, 2013; Iossa and Mar-
timort, 2015). However, any extension that allows the agency frictions
to be relaxed will lead to payoffs that are not qualitatively different. For
instance, a project whose quality is reflected in the generated cash flow,
can be modeled as yt = m(𝜃) + xt , with m(𝜃) an increasing function
of 𝜃 . As xt and yt have the same distribution and only differ in terms
of the starting point (y0 instead of x0 ), the problem can be equivalently
formulated as one in which the cash flow is xt and the effective cost
of exercising the option is I − m(𝜃)
r
(Grenadier and Wang, 2005). More-
over, the payoffs can be adapted to contain a revenue-sharing scheme
between the principal and the agent. However, nothing changes in the
analysis as long as the principal is free to choose a combination of the
two contractual tools (Iossa and Martimort, 2012). In that case, defin-
ing the principal’s benefit as b(𝜃) r
+ 𝛼 x𝛿𝜏 , where the principal claims a
fraction 𝛼 ∈ [0, 1] of the cash flow xt , allows the analysis to proceed
as above.9
2.3. The strategic interaction
The principal delegates the exercise of the investment option to
the agent, whose role is two-fold. First, at t = 0 and depending on
the delegation terms proposed by the principal, the agent exerts (or
does not exert) effort and, subsequently, 𝜃 is drawn from the corre-
sponding distribution, {qH , 1 − qH } or {qL , 1 − qL }, respectively. Then,
given the realization of 𝜃 , at every time point t > 0, the agent has
the action set {wait, invest}. For the time period during which the agent
chooses “wait”, the investment is deferred. As soon as the agent chooses
“invest”, he pays the investment cost I, receives the transfer w from the
principal, and installs the project, triggering the two flows.
As effort is unobservable and costly, there is a principal-agent con-
flict between the two partners. The principal can resolve the conflict
by using an appropriate mechanism. She can induce the agent to exert
effort by offering at t = 0 a contract that commits her to pay a transfer
w at the time of the investment 𝜏 > 0 contingent on the value of the
cash flow at that time, x𝜏 .10 Given the principal’s commitment to the
contract, the agent chooses the exercise time 𝜏 to maximize the value
of his investment option.11 The principal can select the transfer w in
such a way that the agent opts for both exerting effort and aligning
his incentives with those of the principal.12 The timing of the game is
summarized in Fig. 1.
In the following, we derive the optimal contract in two separate
cases based on whether the agent has (subsection 4.2) or does not have
(subsection 4.1) negotiating power. The type of agent becomes known
to the principal in a pre-play negotiation stage, so it is common knowl-
9 curement contracts with public institutions, pharmaceutical companies often
For revenue sharing in regulation, see Sappington and Weisman (1996) and
Sappington (2002), while in a real options framework, see Moretto et al. (2008).
10
Grenadier and Wang (2005).
11
Formally, 𝜏 = inf{t ≥ 0 ∣ xt = x𝜏 }, so the investment time 𝜏 is the first
time that xt hits the threshold that maximizes the value of the investment option
of the agent, x𝜏 . See Dixit et al. (1999) for more details.
12
The contract offered by the principal qualifies as a subgame perfect Nash
equilibrium, as it is determined by backward induction.
4
Economic Modelling 102 (2021) 105586
edge at the time of interaction t = 0.13 We assume that the agent’s
negotiating power is exclusively reflected in the rate of return that he
is willing to accept in order to participate in the PPP. An agent with
negotiating power successfully claims a return rate larger than the hur-
dle rate 𝛿 of the project (i.e. F(x𝜏 , w) > 0), while an agent without
negotiating power fails to do so (i.e. F(x𝜏 , w) ≥ 0). The agent’s ability
to successfully claim a higher rate of return is related to his outside
option, i.e., the payoff that he can count on if the negotiations with
the principal break down.14 A private party’s outside option depends
on several factors, including its degree of risk aversion, the degree of
market competition, its degree of investment diversification, and the
allocation of property rights in the economy.15 Some of these factors
are particularly important in PPPs. For instance, private firms that are
involved in PPPs are usually not well diversified because their portfolios
often comprise few projects that are concentrated in the infrastructure
sector.16 At the same time, because of the complexity and specificity
of PPPs, the degree of market competition is frequently limited, as few
firms have the capacity and expertise to carry them out. Thus, a private
party can take advantage of its market power when negotiating with a
public party.17
3. The investment problem and the first-best solution
We start by presenting the case in which the agent’s action is observ-
able by the principal. For ease of exposition, we also assume for now
that b (𝜃) is a constant. Again, the contract that the principal submits to
the agent commits her to paying w contingent on x𝜏 .
The principal determines the contract terms that maximize her
expected payoff, i.e. her value of the option to invest, conditional on
the agent’s participation. Assuming that x is low enough such that it is
not optimal to invest immediately (i.e. 𝜏 > 0), the principal solves the
following maximization problem:
( )𝛽
x
max R(x𝜏 , w) = max Y (w ) (4)
x𝜏 ,w x𝜏 ,w x𝜏
subject to,
( )𝛽
V (x𝜏 , w) =
x
F (x𝜏 , w) ≥ 0 (5)
x𝜏
13
Pre-play negotiation allows for better planning and exchange of information
between the principal and the agent (Ahadzi and Bowles, 2001, 2004, 2004;
Saussier et al., 2009).
14
de Bettignies and Ross (2009).
15
Grossman and Hart (1986), Hart and Moore (1990), Engel et al. (2014),
Hellowell and Vecchi (2018).
16
Hellowell and Vecchi (2018).
17
See e.g. Engel et al. (2014). For instance, when negotiating long term pro-
implement price discrimination strategies, charging higher prices for innova-
tive medical products to countries with small populations and lack of negotiat-
ing power (Saez, 2019). To address this threat, countries have started to create
alliances to increase their negotiating power. A prominent example is the recent
vaccine alliance formed by France, Germany, Italy and the Netherlands for the
provision of a COVID-19 vaccine by AstraZeneca (Government of Netherlands,
2020).
M. Buso, M. Moretto and D. Zormpas Economic Modelling 102 (2021) 105586

where F(x𝜏 , w) and Y (w) are given by (2) and (3) respectively.18 we can express it as the ratio of the total revenue for the agent per unit
( )
In the maximization problem (4)-(5) both Y (w) and F(x𝜏 , w) are of time xFB + 𝛿 wFB over the investment cost that he pays (I )
( )𝛽
( ) ( )
discounted with xx as the optimal investment threshold lies some-
𝜏
x FB + 𝛿 wFB 𝛿 ′ I − b(𝜃) + 𝛿 ′ b(𝜃) − 𝛽I
where in the future (𝜏 > 0, i.e. x𝜏 > x) and since the terms of the con- hFB
A
= =
r r
= 𝛿. (12)
tract must be specified at t = 0, future values must be properly dis- I I
counted. The term 𝛽 > 1 is the positive root of the characteristic equa- Eq. (12) suggests that, for an agent without negotiating power, the rate
tion Ψ(𝜁) ≡ 12 𝜎 2 𝜁 (𝜁 − 1) + 𝜇𝜁 − r = 0.19 of return is equal to the rate-of-return shortfall 𝛿 .
Rearranging the objective function in Eq. (4), we can write: Conversely, with hFB indicating the project’s rate of return, we can
express it as the ratio of the total revenue generated
( by )the project per
R(x𝜏 , w) = W (x𝜏 ) − V (x𝜏 , w) (6) ( )
unit of time xFB over the net investment cost I − b(𝜃) r
where,
( )𝛽 ( ( )) xFB
hFB = = 𝛿′ . (13)
W (x𝜏 ) =
x x𝜏
− I−
b (𝜃)
(7) I − b(𝜃)
r
x𝜏 𝛿 r
Rearranging the characteristic equation Ψ(𝛽) to read 𝛽−𝛿 1 = 𝜇 + 12 𝛽𝜎 2 ,
represents the project’s total welfare.
Suppose first that the agent does not have negotiating power. In the project’s rate of return can be written as
this case the principal can appropriate the entire surplus generated by 1
hFB = 𝛿 + 𝜇 + 𝛽𝜎 2 . (14)
the project, while the agent merely expects to break even. As F(x𝜏 , w) ⏟⏟⏟ 2
market premium
⏟⏞⏞⏟⏞⏞⏟
increases in w, the principal’s payoff is maximized when the agent’s irreversibility premium
NPV is brought down to zero, that is:
Thus, for every monetary unit invested, the project must pay the
( ) xFB
F xFB , wFB = 0 → wFB = I − (8) market premium 𝛿 and an irreversibility premium 𝜇 + 12 𝛽𝜎 2 . The irre-
𝛿 versibility premium is related to the investment cost and the opportu-
where the superscript FB stands for “first-best”. nity cost that the project needs to pay for when the investment option
The investment threshold xFB that maximizes Eq. (7) is: is exercised. While the investment cost is related to the realization of
( ) the project through the payment of I, the opportunity cost is related
b (𝜃)
xFB = 𝛿 ′ I − (9) to the foregone option to postpone the investment decision further. In
r
the hypothetical case in which the agent privately invests in the project,
( )𝛽 ( )
where 𝛿 ′ = (1 + 𝛽−1 1 )𝛿 and 1 + 𝛽−
1
1
> 1 is the standard option multi- he would choose the investment trigger x = arg max xy y
− I = 𝛿′ I
( ) 𝛿
plier that captures the effect of uncertainty and irreversibility.
Then, from Eq. (8) and Eq. (9), we obtain which is higher than xFB = 𝛿 ′ I − b(𝜃)
r
. This would allow for a hurdle
rate h = x
= 𝛿 ′ which is equal to hFB . Despite the fact that the rate of
FB
𝛽 b(𝜃)
r
−I I
w = . (10) return remains the same (h = hFB ), the project is delayed when it is pri-
𝛽 −1
vately executed (x > xFB ) because the investor does not account for the
In sum, the contract that the principal submits to an agent in the first- public benefit flow b (𝜃).
best is { (
{ FB FB } ) 𝛽 b(𝜃) −I } Finally, suppose that the agent has negotiating power. In this case
x ,w = 𝛿 ′ I − b(𝜃)
r
, 𝛽−r
1
.20 the contract is accepted if it is associated with a rate of return higher
{ FB FB } than 𝛿 . The principal again solves the problem (4)-(5) but condition (4)
Given x , w , the total welfare becomes
is slack. While the principal can still dictate the investment threshold
( ) ( )
x 𝛽 1 b (𝜃) that maximizes (7), the transfer will have to be higher than wFB to
W (xFB ) = I− . (11)
x FB 𝛽 −1 r ensure participation. Therefore, although the project’s rate of return
remains equal to 𝛿 ′ , the agent’s rate of return is marginally higher than
A project’s rate of return and NPV at the time of the investment 𝛿.
are two sides of the same coin. An investment with a rate of return 𝛿
has a NPV that is equal to 0 at the time of the investment, while an
4. The investment problem under moral hazard
investment with a rate of return higher than 𝛿 has a positive NPV at the
time of the investment.21 With hFB
A
indicating the agent’s rate of return,
Now suppose that b (𝜃) is a random variable (as described in Section
2) and that the principal cannot verifiably observe the agent’s action.
The principal can design a mechanism to provide incentives to the agent
18
Demougin and Helm (2006) show that variations in the agent’s limited lia- in order to reveal his private action truthfully. While this mechanism
bility constraint in a principal-agent framework (V(x𝜏 , w) ≥ 0 in our case) and cannot be contingent on the agent’s unobservable effort, it can be con-
the bargaining power coefficient in a Nash-bargaining game result in the same tingent on the cash flow xt .
set of contracts. This finding justifies the interpretation of a slack Eq. (5) as a In contrast to the first-best situation, under moral hazard the prin-
manifestation of the agent’s negotiating power. We are grateful to an anony- cipal submits, not one, but two contracts to the agent, one for each
mous referee for bringing this result to our attention.
( )𝛽 realization of 𝜃 : {xi , wi }, i ∈ {1, 2}. The principal chooses the {xi , wi },
19
The term xx corresponds to the time zero price of an Arrow-Debreu secu- i ∈ {1, 2} that maximize her ex-ante investment option value condi-
𝜏
rity that pays one monetary unit the first moment the threshold x𝜏 is reached. tional on participation of an effort exerting agent. The principal’s ex-
It is also known as the “expected discount factor” (Dixit and Pindyck, 1994, pp. ante payoff is:
315–316). ( )𝛽 ( )𝛽
20 For the investment threshold xFB and the transfer wFB to make sense, we x x
( ) R(x1 , x2 , w1 , w2 ) = qH Y1 + (1 − qH ) Y2 (15)
require: 𝛽 b(𝜃) > I > b(𝜃) . For 𝜏 > 0, the initial value must be x < 𝛿 ′ I − b(𝜃) . x1 x2
r r r
21
The hurdle rate for an investor who is accounting for the uncertainty and b
where Yi = (𝜃r i ) − wi , i ∈ {1, 2}.
irreversibility of a project is not 𝛿 , but the adjusted discount rate 𝛿 ′ = (1 +
FB
1
𝛽−1
)𝛿 such that b(𝜃)
r
+ x𝛿 ′ − I = 0 (Dixit, 1992, p.130; Dixit and Pindyck, 1994,
p. 142). Moreover, lim 𝛿 ′ = 𝛿 .
𝜎 →0

5
M. Buso, M. Moretto and D. Zormpas Economic Modelling 102 (2021) 105586

Eq. (15) is maximized subject to both ex-ante and ex-post con- In Proposition 1, the transfers w∗1 and w∗2 are presented as functions
straints. The ex-ante constraints are: of the corresponding investment triggers x1∗ and x2∗ to emphasize that xt
( )𝛽 ( )𝛽 ( )𝛽 is the only contractible component of the PPP and because the menu of
x x x
qH F1 + (1 − qH ) F2 − 𝜉 ≥ qL F1 contracts determines the investment thresholds and transfers as combi-
x1 x2 x1
nations. xiFB and wFB are reminiscent of xFB and wFB from Eqs. (9) and
( )𝛽 i
x (10) and correspond to the investment thresholds and transfers chosen
+ (1 − q L ) F2 (16) in the first-best when 𝜃 = 𝜃 i , i ∈ {1, 2}.23
x2
( )𝛽 ( )𝛽 From Eqs. (23.1)-(23.2) we see that the principal can guarantee
x x that the investment will occur as soon as xiFB , i ∈ {1, 2} is reached. For
qH F1 + (1 − qH ) F2 − 𝜉 ≥ 0 (17)
x1 x2 𝜃 = 𝜃 2 , the principal does so by setting F2 (x2∗ , w∗2 ) = 0. For 𝜃 = 𝜃 1 ,
she must instead pay an information premium Φ1 > 0 to induce the
where Fi = x𝛿i + wi − I, i ∈ {1, 2}.
agent to exert effort which results in F1 (x1∗ , w∗1 ) > 0. As for the condi-
Ineq. (16) is the agent’s ex-ante incentive compatibility constraint
tion required for the principal to induce the agent to exert effort (see
which guarantees that the agent (weakly) prefers to exert effort. In
Section A.2 of the Appendix):
other words, Ineq. (16) ensures that there is no unobservable action
at the time of the investment. Ineq. (17) is the agent’s ex-ante partici- qL
ΔqA ≥ 𝜉 + 𝜉 (24)
pation constraint which ensures that the private party will abide by the Δq
public party’s choice of transfers and investment triggers. ( )𝛽 ( )
Finally, the principal needs to ensure that the agent has incentives where A = W (x1FB ) − W (x2FB ) > 0 and W (xiFB ) = x 1
𝛽−1
I − b(𝜃r i )
xFB
i
to invest ex-post. The relevant constraints are:
is the project’s total welfare in the first-best, i ∈ {1, 2}.24
F1 ≥ 0 (18) The left-hand side of Ineq. (24) indicates the expected gain related to
the exertion of effort. This gain comes from the fact that the value of the
total welfare when the project turns out to be of high-quality, W (x1FB )
F2 ≥ 0 (19)
(which is greater than the total welfare when the project turns out to
and be of low-quality, W (x2FB )) becomes more likely when effort is exerted.
Conversely, the right-hand side of Ineq. (24) is the cost of inducing
w1 ≥ 0 (20)
effort exertion, which is given by the direct effort exertion cost 𝜉 plus
the limited liability rent ΔqLq 𝜉 (Laffont and Martimort, 2002, p. 157).25
w2 ≥ 0 (21) Alternatively, Ineq. (24) can be written as
Ineqs. (20) and (21) must hold as the transfers from the principal to ( )𝛽 ( )
x b (𝜃1 ) ∗ ≥ q W (xFB ) + ΔqW (xFB ).
the agent cannot be negative. Meanwhile, Ineqs. (18) and (19) comple- qH − w 1 L 1 2
(25)
x1FB r
ment the ex-ante constraints and provide insurance to the agent who is
guaranteed to receive a non-negative ex-post payoff, irrespective of the
In Ineq. (25), the right-hand side is positive, such that b(𝜃r 1 ) > w∗1 . One
realization of 𝜃 .22
can easily show that b(𝜃r 2 ) > w∗2 . Thus, when the principal chooses to
induce effort exertion, the discounted flow of public benefits is strictly
4.1. Optimal contracts when the agent does not have negotiating power
larger than the transfer that she pays, regardless of the realization of 𝜃 .
Suppose that the agent fails to claim Fi > 0, i ∈ {1, 2}. In
Section A.1 of the Appendix we show that the problem (15)–(21) can 4.2. Optimal contracts when the agent has negotiating power
be slightly reduced as Ineqs. (17) and (18) are always slack. The princi-
pal’s problem reduces to the maximization of the objective function in Suppose now that the agent can successfully claim Fi > 0, i ∈
Eq. (15) subject to Ineq. (16): {1, 2}. In this case, we solve the problem (15)-(21) anew, assuming
that Ineqs. (18) and (19) are slack.
( )𝛽 ( )𝛽
x x 𝜉 Solving we obtain:
F1 − F2 ≥ (22)
x1 x2 Δq
Proposition 2. When the agent has negotiating power, the principal com-
and Ineqs. (19)–(21). mits to the following menu of incentive feasible contracts:
Solving the maximization problem, we obtain: { ( )} { }
x1∗∗ , w∗∗
1
x1∗∗ = x1FB , wFB
1
+ Φ1 + Φ2 (26.1)
Proposition 1. When the agent does not have negotiating power, the prin-
cipal commits to the following menu of incentive feasible contracts: { ( )} { }
𝛿 ′ b (𝜃2 )
{ ( )} { } x2∗∗ , w∗∗
2
x2∗∗ = x2FB + ,0 (26.2)
x1∗ , w∗1 x1∗ = x1FB , wFB + Φ1 (23.1) qH r
1

{ ( )} { }
x2∗ , w∗2 x2∗ = x2FB , wFB
2
(23.2)
23
For the contract to make sense we require 𝛽 b(𝜃r 2 ) > I > b(𝜃1 )
and x <
( ) b(𝜃i ) ( ) r
𝛽 −I 𝛿 ′ I − b(𝜃r 1 ) .
where xiFB = 𝛿 ′ I − b(𝜃r i ) , wFB
i
= r
𝛽−1
, i ∈ {1, 2}, and Φ1 ≡
( )−𝛽 24
Since in the first-best the agent’s NPV is set equal to 0, the total value of the
𝜉 x
Δq x1FB
> 0. project and the total welfare for the principal coincide. This is obvious from Eq.
( )𝛽
(6) as R(xiFB , wFB
i
) = W (xiFB ) − V (xiFB , wFB
i
) and V (xiFB , wFB
i
) = xxFB Fi (xiFB , wFB
i
)=
i
Proof. See Section A.1 of the Appendix. ■ 0 because of Fi (xiFB , wFB ) = 0. Consequently, R(xiFB , wFB ) = W (xiFB ) and A =
i i
R(x1FB , wFB
1
) − R(x2FB , wFB
2
) = W (x1FB ) − W (x2FB ), i ∈ {1, 2}.
25
Note that Eq. (24) can be written as ΔqA ≥ qH Δ𝜉q . Grenadier and Wang
𝜉
(2005) call the term Δq
the cost–benefit ratio of inducing effort exertion. The
22
Ineqs. (18) and (19) are reminiscent of Ineq. (5) in the spirit of Demougin numerator is the cost of exerting effort and the denominator is the change in
and Helm (2006). the likelihood of drawing a higher quality project 𝜃 1 as a result of effort.

6
M. Buso, M. Moretto and D. Zormpas Economic Modelling 102 (2021) 105586

( ) b(𝜃 )
𝛽 r i −I
b
where xiFB = 𝛿 ′ I − (𝜃r i ) , wFB = 𝛽− , i ∈ {1, 2}, and Φ2 ≡ These results also allow us to evaluate how this ability is reflected in
i 1
( ) ( xFB )𝛽 the project’s rate of return. Denoting by h∗Ai , i = 1, 2 the agent’s rate of
1−qH 𝛽 b(𝜃2 )
q 𝛽−1 r
+ 𝛽−I 1 1
∗∗ > 0. return when he does not have negotiating power, we have:
x2
H
( ) ( )
x1FB + 𝛿 w∗1 𝛿 ′ I − b(𝜃r 1 ) + 𝛿 ′ b(𝜃r 1 ) − 𝛽I + 𝛿Φ1
Proof. See Section A.3 of the Appendix. ■ ∗
hA1 = = (29.1)
I I
Unlike the case discussed in subsection 4.1, the principal here faces
Φ1
an insurance-efficiency trade-off. In fact, she finds it optimal to distort =𝛿+ 𝛿>𝛿
I
the menu of contracts in terms of both timing and transfers. From Eqs.
(26) we see that the principal chooses an investment threshold that is when 𝜃 = 𝜃 1 .
b(𝜃1 )
equal to the first-best when the project turns out to be of high-quality Additionally, because of r
> w∗1 , we have h∗A1 = 𝛿 ′ +
( )
(𝜃 = 𝜃1 ) but otherwise allows for a time distortion, that is, x1∗∗ = x1FB 𝛽
w∗1 − 𝛽−
b(𝜃1 )
( )
1 r
and x2∗∗ > x2FB . Moreover, the optimal transfer is higher than the one 𝛿 I
< 𝛿 ′ . Consequently, h∗A1 ∈ 𝛿, 𝛿 ′ . Moreover, when
paid in the first-best for a high-quality project (𝜃 = 𝜃1 ) and lower than 𝜃 = 𝜃 2 , we have:
( ∗∗ ) ( )
the one paid for a low-quality project, (𝜃 = 𝜃2 ), i.e. w∗∗ x1 > w∗1 x1∗
( ) ( ) ( 1) x2FB + 𝛿 wFB
and w∗∗2
x2∗∗ = 0. The inequality w∗∗1
x1∗∗ > w∗1 x1∗ is attributed to h∗A2 = 2
=𝛿 (29.2)
I
the agent’s ability to claim a rate of return higher than 𝛿 . In addition,
( ) ( ∗∗ )
similar to w∗1 x1∗ , the transfer w∗∗ x1 contains the term Φ1 > 0 where the equality h∗A2 = 𝛿 is attributed to the principal’s decision to
1 { }
which accounts for the rents that must be paid to resolve the agency choose x2∗ , w∗2 so that F2 (x2∗ , w∗2 ) = 0. Accounting for the fact that the
conflict. Conversely, the term Φ2 > 0 measures the cost attributed menu of contracts in Eqs. (23) allows for two investment thresholds,
to the agent’s negotiating power. The equality w∗∗ 2
= 0 refers to the fact that is, one for each realization of 𝜃 , we can get an idea of the agent’s
that, when 𝜃 = 𝜃 2 , the principal finds it too costly to guarantee optimal ex-ante rate of return by calculating h∗A
timing so she allows for x2∗∗ > x2FB saving at least in terms of transfer.26
Φ1
As for the condition that must hold for the principal to induce effort h∗A = qH h∗A1 + (1 − qH )h∗A2 = 𝛿 + qH𝛿 < 𝛿′ .
⏟⏟⏟ I
exertion we have (see Section A.4 of the Appendix):
market premium
⏟⏟⏟
qL moral hazard premium
ΔqA ≥ 𝜉 + 𝜉 + ΔR (27) (30)
Δq
where ΔR = R(x1∗ , x2∗ , w∗1 , w∗2 ) − R(x1∗∗ , x2∗∗ , w∗∗
1
, w∗∗
2
) > 0.27 This differ- Eq. (30) shows that the agent’s ex-ante rate of return A is larger h∗
ence measures the agency cost associated with the agent’s negotiating than the rate of return that corresponds to the case without agency
( )
power. Ineq. (27) is clearly more demanding than Ineq. (24), so the conflicts hFB = 𝛿 , but it is still lower than the project’s rate of return
( FB ) A ( )
principal chooses to induce effort exertion less frequently. This result h = 𝛿 ′ . The reasoning behind h∗A ∈ 𝛿, 𝛿 ′ is as follows. The agent
is standard in the literature, as, combined with limited liability con- needs to be remunerated for the effort that he exerts, so he gets the
straints, the problem of moral hazard generates an information transfer premium qH Φ1 𝛿∕I on top of the market rate 𝛿 . However, as the agent
from the principal to the agent that distorts the decisions concerning cannot successfully claim a rate of return higher than 𝛿 irrespective
the optimal effort (Laffont and Martimort, 2002). of the realization of 𝜃 , the ex-ante rate of return will not reach 𝛿 ′ .
In addition, Ineq. (27) can be written as Therefore, an agent who accepts the menu of contracts in Eqs. (23)
( )𝛽 ( ) expects to receive a rate of return that is lower than the rate of return
x b (𝜃1 ) that an option-holder would have accepted in order to exercise the same
qH − w∗∗
1
≥ qL W (x1FB ) + ΔqW (x2FB )
FB
x1 r investment option, that is 𝛿 ′ .
( )𝛽 Further, as xi∗ = xiFB , i ∈ {1, 2}, the project’s rate of return is still
⎛ ⎞
x b (𝜃2 ) ⎟ equal to 𝛿 ′ , i.e.:
+ (1 − qH ) ⎜W (x2FB ) − . (28)
⎜ x2∗∗ r ⎟
⎝ ⎠ h∗ = qH h∗1 + (1 − qH )h∗2 = 𝛿 ′ (31)
If qH is sufficiently high, then the last term on the right-hand side where h∗i , i ∈ {1, 2}, is the project’s rate of return with high-quality and
of Ineq. (28) is negligible, and condition (28) becomes equivalent to low-quality respectively. Therefore, the menu of contracts in Eqs. (23)
condition (25). Thus, when the principal chooses to induce effort exer- simply transfers part of the project’s return from the principal to the
tion, the discounted flow of public benefits is strictly larger than the agent without altering the project’s risk profile.
transfers that the principal pays, regardless of the realization of 𝜃 , i.e. Proceeding in the same way, from Proposition 2, we obtain the
b(𝜃i )
r
> w∗∗
i
, i ∈ {1, 2}.28 However, if qH happens to be low, then Ineq. agent’s return rates as:
(28) does not necessarily result in b(𝜃r 1 ) > w∗∗ but might hold even with
− 𝛽−𝛽 1 b(𝜃r 1 )
1
b(𝜃1 ) x1FB + 𝛿 w∗∗ w∗∗
< w∗∗ because, if qH is low, then the principal gains access to h∗∗ = 1
= 𝛿′ +
1
𝛿
r 1 ( ) A1 I I
a costless project w∗∗ 2
= 0 generating a positive public benefit flow
(b (𝜃2 ) > 0) with high probability (1 − qH ). = 𝛿+
Φ1 + Φ2
𝛿 , if 𝜃 = 𝜃1 and (32.1)
I
5. The effect of the agent’s negotiating power on the return rates 1−qH b(𝜃2 )
x2∗∗ qH r
h∗∗
A2
= = 𝛿′ + 𝛿 ′ > 𝛿 ′ , if 𝜃 = 𝜃2 . (32.2)
Our findings suggest that the agent’s ability to claim a high rate I I
of return affects the conditions under which effort exertion is induced. Because of x1∗∗ = x1∗ , x2∗∗ > x2∗ , w∗∗ > w∗1 and w∗∗ = 0, the comparison
1 2
between Eqs. (29) and (32) results in:
26
This result is in line with the evidence that low-quality projects may be Proposition 3. The rate of return of an agent with negotiating power is
substantially delayed (Ng and Loosemore, 2007; Villani et al., 2017). strictly larger than the rate of return of an agent without negotiating power,
27
We show that ΔR > 0 in Section A.1 of the Appendix. irrespective of the realization of 𝜃 , i.e.
{ }
This is similar to what we found for xi∗ , w∗i , i ∈ {1, 2}, that is, (𝜃r i ) > w∗i ,
28 b

i ∈ {1, 2}. h∗∗

Ai
> h∗Ai , i ∈ {1, 2} . (33)

7
M. Buso, M. Moretto and D. Zormpas Economic Modelling 102 (2021) 105586

Proof . Straightforward from Proposition 1 and 2. ■ agent’s negotiating power on the project’s efficiency as

h∗ h∗∗
The increase from A1 to A1 is attributed to the agent’s ability to 𝜕(h∗∗ − h∗ )
( ) > 0.
claim more w∗∗ > w∗1 of a project that still occurs when the x1FB is 𝜕𝜎
1
reached. Conversely, the increase from h∗A2 to h∗∗ is attributed to the Hence, an increase in uncertainty increases the premium that a PPP
( ) A2 involving an agent with a negotiating advantage must pay.
further postponement of the project x2∗∗ > x2FB and to the principal’s
( )
decision to pay no transfer w∗∗
2
=0 .
As for the return rates when the agent has negotiating power we 6. Conclusion
have:
In this paper we discuss the optimal design of a PPP, assuming that
x1FB there is moral hazard between the public and the private party. We
h∗∗
1
= = 𝛿 ′ , if 𝜃 = 𝜃1 and (34.1)
I − b(𝜃r 1 ) also allow for two types of agents, that is, one with negotiating power
1 b(𝜃2 )
and one without such power. Departing from Grenadier and Wang
x2∗∗ qH r (2005), we show that the public party can resolve the agency conflict by
∗∗
h2 = =𝛿 + ′
𝛿 ′ > 𝛿 ′ , if 𝜃 = 𝜃2 . (34.2)
I − b(𝜃r 2 ) I − b(𝜃r 2 ) employing a properly designed mechanism. However, the mechanism
that the public party chooses depends on the private party’s negotiating
Comparing Eqs. (32) and Eqs. (34) we find that when the project hap- power. If the private party does not have negotiating power, then moral
pens to be of high-quality (𝜃 = 𝜃1 ), the principal is willing to bear a hazard has no effect on the timing of the investment. Conversely, if the
negative payoff as long as doing so guarantees that the project will be private party has negotiating power, then the first-best timing is not
delivered when the first-best investment threshold x1FB is reached. In guaranteed. This time discrepancy is reflected in the project’s reduced
fact, from Eqs. (32.1) and (34.1), if w∗∗ 1
− b(𝜃r 1 ) > 𝛽−1 1 b(𝜃r 1 ) , we have overall efficiency, as the project must pay a higher return to attract the
hA1 > h1 = 𝛿 . Conversely, when the project happens to be of low-
∗∗ ∗∗ ′ private investor.
quality (𝜃 = 𝜃2 ), the principal prefers to remunerate the agent with a The main message that our work conveys is that, even if a properly
high rate of return by postponing the investment. In this case the rate designed mechanism is used to resolve agency conflicts between the
of return that the principal requires is higher than 𝛿 ′ , as is reflected in partners of a PPP, there is no guarantee that the first-best solution will
h∗∗ > 𝛿 ′ . In sum: be reached. The agent’s negotiating power is a source of inefficiency
2
that may lead to underinvestment in PPPs and limited use of incen-
Proposition 4. When the project happens to be of high-quality (𝜃 = 𝜃1 ), tive contracts by public administrations. These findings are particularly
then if w∗∗
1
≶ 𝛽−𝛽 1 b(𝜃r 1 ) , we have h∗∗
A1
≶ h∗∗
1
= 𝛿 ′ . When instead the project informative in the current economic crisis caused by the COVID-19 pan-
happens to be of low-quality (𝜃 = 𝜃2 ), then we have h∗∗
2
> h∗∗
A2
> 𝛿′ . demic, when private firms seem reluctant to form long term partner-
Proof . Straightforward from Proposition 1 and 2. ■ ships with public parties and are more likely to take advantage of their
negotiating position (Knight, 2020).
In order to conduct an overall comparison, when the agent has nego- Although the modeling of the pre-play negotiation stage when the
tiating power, the project’s ex-ante rate of return can be approximated type of the agent is specified is beyond the scope of this study, our
by results suggest that the way public and private parties bargain can
1 determine (to a large extent) a PPP’s likelihood of success. In this
h∗∗ = 𝛿 + 𝜇 + 𝛽𝜎 2
⏟⏟⏟ 2 respect, opening the “black box” of pre-contractual negotiation could
market premium
⏟⏞⏞⏟⏞⏞⏟
irreversibility premium be a useful extension of this work.

b(𝜃2 ) (35) Declaration of competing interest

1 − qH
+ r
𝛿′ > h∗ = 𝛿 ′ .
qH I − b(𝜃r 2 )
⏟⏞⏞⏞⏞⏞⏞⏞⏞⏞⏟⏞⏞⏞⏞⏞⏞⏞⏞⏞⏟ The authors declare that they have no known competing financial
negotiating power premium interests or personal relationships that could have appeared to influence
the work reported in this paper.
Ineq. (35) suggests that when a project’s completion is delegated to
an agent with negotiating power, the project must have a higher rate of
Acknowledgements
return than a similar project that is delegated to an agent without nego-
tiating power (h∗∗ > h∗ ). The effect of this “extra” return is an under-
The authors wish to thank the participants of the following events:
valuation of the project’s current (time zero) total value with respect
10th IRMBAM in Nice; EARIE 2019 in Barcelona; JEI 2019 in Madrid;
to the project’s total value with only moral hazard (see Section A.5 of
Annual Meeting of the ASSET 2019 in Athens; Technis webinar; sem-
the Appendix). Indeed, the presence of an agent with negotiating power
inars held at the University of Padova. All remaining errors are ours.
comes at a cost for the project’s overall efficiency that needs to pay for
The authors gratefully acknowledge the financial support of the Uni-
whatever the agent asks in order to accept the delegation terms pro-
versity of Padova (BIRD173594). This work received funding from the
posed by the principal.
b(𝜃2 ) CY Initiative of Excellence (grant “Investissements d’Avenir” ANR-16-
𝛽
Finally, the difference h∗∗ − h∗ = 1−q qH r
b(𝜃 ) 𝛽−1
𝛿 allows us to IDEX-0008) and was developed during Dimitrios Zormpas’ stay at the
H I − r2
CY Advanced Studies whose support is gratefully acknowledged.
show that an increase in the level of risk emphasizes the effect of the

8
M. Buso, M. Moretto and D. Zormpas Economic Modelling 102 (2021) 105586

A. Appendix

A.1. Proof of Proposition 1

The principal’s problem is:

( )𝛽 ( )𝛽
x x
max qH Y1 + (1 − qH ) Y2 (A.1)
{xi ,wi },i∈{1,2} x1 x2
subject to,
( )𝛽 ( )𝛽 ( )𝛽 ( )𝛽
x x x x
qH F1 + (1 − qH ) F2 − 𝜉 ≥ qL F1 + (1 − qL ) F2 (A.2)
x1 x2 x1 x2
( )𝛽 ( )𝛽
x x
qH F1 + (1 − qH ) F2 − 𝜉 ≥ 0 (A.3)
x1 x2

F1 ≥ 0 (A.4)

F2 ≥ 0 (A.5)

w1 ≥ 0 (A.6)

w2 ≥ 0 (A.7)
b(𝜃i ) xi
where Yi = − wi and Fi = 𝛿 + wi − I, i ∈ {1, 2}.
r
Ineq. (A.2) can be written as
( )𝛽 ( )𝛽
x x 𝜉
F1 − F2 ≥ . (A.8)
x1 x2 Δq
From Ineq. (A.8) we obtain
( )𝛽 ( )𝛽
x 𝜉 x 𝜉
F1 ≥ + F2 ≥ > 0. (A.9)
x1 Δq x2 Δq
This means that Ineq. (A.4) is not binding.
From Ineq. (A.3) we have
( )𝛽 ( )𝛽
x 1 − qH x 𝜉
F1 + F2 ≥ . (A.10)
x1 qH x2 qH
( )𝛽 ( )𝛽
From Ineq. (A.9) we have xx F1 ≥ Δ𝜉q . Since Δ𝜉q > q𝜉 , also xx F1 > q𝜉 which means that Ineq. (A.10), and consequently Ineq. (A.3), is slack.
1 H 1 H
In sum, the reduced version of the principal’s problem is:
( )𝛽 ( )𝛽
x x
max qH Y1 + (1 − qH ) Y2 (A.11)
{xi ,wi },i∈{1,2} x1 x2
subject to the following conditions:
( )𝛽 ( )𝛽
x x 𝜉
F1 − F2 ≥ (A.12)
x1 x2 Δq

F2 ≥ 0 (A.13)

w1 ≥ 0 (A.14)

w2 ≥ 0 (A.15)

The Lagrangian is:

( )𝛽 ( ) ( )𝛽 ( )
x b (𝜃1 ) x b (𝜃2 )
L = qH − w 1 + (1 − q H ) − w2
x1 r x2 r
(( ) ( ) )
𝛽( ) 𝛽( )
x x1 x x2 𝜉
+ 𝜆1 + w1 − I − + w2 − I −
x1 𝛿 x2 𝛿 Δq
(x )
+ 𝜆2 2
+ w2 − I
𝛿
+ 𝜆3 w 1
+ 𝜆4 w 2

9
M. Buso, M. Moretto and D. Zormpas Economic Modelling 102 (2021) 105586

where 𝜆1 , 𝜆2 , 𝜆3 and 𝜆4 are the four Lagrangian multipliers, one for each of the four Ineqs. (A.12)–(A.15).
The first-order condition with respect to w1 gives:
( )𝛽
( )
x
𝜆3 = q H − 𝜆1
AC AC
(A.16)
x1AC

where the superscript AC stands for “agency conflict.”

As for Eq. (A.16), it is satisfied in three possible cases:

i) qH = 𝜆AC
1
> 0. The positivity of 𝜆AC
1
suggests that Ineq. (A.12) is binding. Additionally, because of qH = 𝜆AC
1
we have 𝜆AC
3
= 0 which means wAC1
>
0.
ii) qH > 𝜆AC
1
> 0. Again, the positivity of 𝜆AC
1
suggests that Ineq. (A.12) is binding. However, since qH > 𝜆AC
1
we have 𝜆AC
3
> 0 which in turn suggests
wAC
1
= 0.
iii) qH > 𝜆AC
1
= 0. As 𝜆AC
1
= 0, Ineq. (A.12) is slack. Conversely, as qH > 𝜆AC1
we have 𝜆AC
3
> 0 which suggests wAC
1
= 0.
The first-order condition with respect to w2 gives
( )𝛽
( )
x
𝜆2 + 𝜆4 = 1 − q H + 𝜆1
AC AC AC
. (A.17)
x2AC

The right-hand side of the equality is strictly positive, so either 𝜆AC

2
, 𝜆AC
4
, or both are positive. We have a total of three cases.

a) 𝜆AC
2
= 0, 𝜆AC
4
> 0. In this case Ineq. (A.13) is slack and Ineq. (A.15) is binding.
b) 𝜆2 > 0, 𝜆AC
AC
4
= 0. In this case Ineq. (A.13) is binding and Ineq. (A.15) is slack.
c) 𝜆AC
2
> 0, 𝜆AC
4
> 0. In this case both inequalities are binding.
The first-order condition with respect to x1 gives
[ ( ) ( )]
𝛽 b (𝜃1 )
𝜆AC x1AC = 𝛿 qH wAC − − 𝜆AC wAC −I . (A.18)
1 𝛽−1 1 r 1 1

The first-order condition with respect to x2 gives

( )𝛽 ( ) ( )
𝜆AC ⎡ (1 − qH ) b(𝜃2 ) − wAC − 𝜆AC wAC − I ⎤
x ⎢ r 2 1 2 𝛽 − 1⎥
2
= 𝛽 − 𝜆AC . (A.19)
𝛿 AC
x2 ⎢ AC
x2 1 𝛿 ⎥
⎣ ⎦
Given (A.16)-(A.19) we discuss the possible solutions.

A.1.1. Case ia
In this case we have qH = 𝜆∗∗
1
> 0 and 𝜆∗∗
2
= 0, 𝜆∗∗
4
> 0. In other words, Ineqs. (A.13) and (A.14) are slack whereas Ineqs. (A.12) and (A.15) are
binding. From these we have

x1∗∗ = x1FB , (A.20)

𝛿 b (𝜃2 ) 𝛽
x2∗∗ = x2FB + , (A.21)
qH r 𝛽−1
( )
where xiFB = 𝛿 ′ I − b(𝜃r i ) , i ∈ {1, 2}.
From the binding (A.12) we obtain:
( ) ( FB )𝛽 ( )−𝛽
1 𝛽 b (𝜃2 ) x1 𝜉 x
w∗∗ = − w FB
+ + wFB (A.22)
1 qH 𝛽 − 1 r 2
x∗∗ Δq xFB 1
2 1
( ) ( )−𝛽
I + 𝛽 b(𝜃r 2 ) 1−q qH xFB 𝛽 𝜉 x
= H 1
+ + wFB (A.23)
𝛽−1 x∗∗ 2
Δq xFB 1
1

b(𝜃i )
𝛽 −I
where wFB
i
= r
𝛽−1
, i ∈ {1, 2}.
Finally, from 𝜆∗∗
4
> 0 we have w∗∗
2
= 0.
The inequality 𝛽 b(𝜃r 2 ) > I > b(𝜃r 1 ) guarantees xi∗∗ > 0, wFB > 0, i ∈ {1, 2}. From Eq. (A.23) we see that w∗∗ > 0, so Ineq. (A.14) is indeed slack. At
{ ( )} i 1
the same time, the solution xi , wi xi
∗∗ ∗∗ ∗∗ , i ∈ {1, 2} satisfies the always slack Ineqs. (A.3) and (A.4) as well as Ineq. (A.13) which is the slack in
this case.

A.1.2. Case ib
In this case we have qH = 𝜆∗1 > 0, 𝜆∗2 > 0 and 𝜆∗4 = 0. In other words, Ineqs. (A.14) and (A.15) are slack whereas Ineqs. (A.12) and (A.13) are
binding. From these we obtain:

x1∗ = x1FB (A.24)

10
M. Buso, M. Moretto and D. Zormpas Economic Modelling 102 (2021) 105586

x2∗ = x2FB (A.25)

( )−𝛽
𝜉 x
w∗
1
= wFB
1
+ (A.26)
Δq x1FB

w∗2 = wFB
2
(A.27)
( ) b(𝜃 )
𝛽 r i −I
b
where again xiFB = 𝛿 ′ I − (𝜃r i ) and wFB
i
= 𝛽− 1
, i ∈ {1, 2}.
b(𝜃2 ) b(𝜃1 )
As earlier, the inequality 𝛽 r > I > r guarantees the positivity of w∗i and that xiFB , i ∈ {1, 2}. One can also easily check that the solution
{ ( )}
xi , w∗i xi∗ , i ∈ {1, 2} satisfies the always slack Ineqs. (A.3) and (A.4).
∗

A.1.3. Case ic
In this case we have qH = 𝜆ic
1
> 0 and 𝜆ic2 > 0, 𝜆ic4 > 0. In other words, only Ineq. (A.14) is slack. From Eq. (A.18) we have x1ic = x1FB and from
( )−𝛽1 ( ) b(𝜃 )
FB + 𝜉 𝛽 r 1 −I
the binding Ineq. (A.12) we have wic
1
= w 1 Δq
x
ic where x1FB = 𝛿 ′ I − b(𝜃r 1 ) and wFB
1
= 𝛽− 1
. At the same time, from the binding Ineq.
x1
(A.15) we have wic
2
= 0. As wic2 = 0, we expect x2ic = x which is a contradiction since, by assumption, x2ic > x.

A.1.4. Cases iia, iib and iic

In all of these cases we have qH > 𝜆ii1 > 0, so wii1 = 0. Given this, from the first-order condition (A.18) we obtain
( )
𝛽 qH b (𝜃1 )
ii
x1 = 𝛿 I − ii . (A.28)
𝛽 −1 𝜆 r
1

xii
The always slack Ineq. (A.4), 𝛿1 + wii1 − I > 0, is satisfied only if I > 𝛽 qHii b(𝜃r 1 ) . Since qH > 𝜆ii1 and b (𝜃1 ) > b (𝜃2 ), the inequality I > 𝛽 qHii b(𝜃r 1 ) is
𝜆1 𝜆1
stronger than the inequality I > 𝛽 b(𝜃r 2 ) , although this result contradicts the condition 𝛽 b(𝜃r 2 ) > I > b(𝜃r 1 ) .

A.1.5. Cases iiia, iiib and iiic

In all of these cases we have qH > 𝜆iii
1
= 0. Plugging 𝜆iii
1
= 0 into Eq. (A.18) we obtain b(𝜃r 1 ) = wiii
1
. Because of qH > 𝜆iii
1
we have 𝜆iii
3
> 0, which
suggests that wiii
1
= 0. Consequently, Cases iiia, iiib and iiic result in b(𝜃r 1 ) = 0 which is a contradiction as, by assumption, b (𝜃1 ) > 0.

A.1.6. The optimal solution { ( )} { ( )}

In sum, the principal must choose between xi∗ , w∗i xi∗ and xi∗∗ , w∗∗
i
xi∗∗ , i ∈ {1, 2}. If the principal chooses the former, she obtains
( )𝛽 ( ) ( )𝛽 ( )
b(𝜃1 ) b(𝜃2 )
qH xFB r
− w∗1 + (1 − qH ) xFB r
− wFB
2
. A similar expression occurs if she chooses the latter. Referring to the difference between
x1 x2
the two as ΔR, we have
b(𝜃2 ) ( )𝛽
⎛
( )𝛽
⎞
( )𝛽
x I − b(𝜃r 2 ) x x
ΔR = r
+ ⎜q H ⎟ > 0.
+ (1 − qH ) (A.29)
𝛽 − 1 x2 ∗∗ 𝛽 −1 ⎜ x2∗∗ ⎟ x2FB
⎝ ⎠
{ ( )}
The positivity of ΔR suggests that the principal opts for xi∗ , w∗i xi∗ , i ∈ {1, 2}.
{ ( )} ( )𝛽
( )
As for the agent, when xi∗ , w∗i xi∗ , i ∈ {1, 2} is the submitted menu of contracts, the ex-ante option value is qH xFB F1 x1FB , w∗1 +
x1
( )𝛽 { ( )}
( )
(1 − qH ) xFB F2 x2FB , wFB
x2 2
− 𝜉 . We have a similar expression when xi∗∗ , w∗∗ i
xi∗∗ , i ∈ {1, 2} is chosen. Referring to the difference between
the two as ΔV, we have
( )𝛽 ( )𝛽
( ) ( )
x x
ΔV = qH FB w∗1 − w∗∗
1
− (1 − q H ) ∗∗
F2 x2∗∗ , w∗∗
2
. (A.30)
x1 x2
( ) { ( )} { ( )}
As w∗1 < w∗∗
1
and F2 x2∗∗ , w∗∗
2
> 0 we have ΔV < 0, so the agent prefers xi∗∗ , w∗∗
i
xi∗∗ to xi∗ , w∗i xi∗ , i ∈ {1, 2}.

A.2. Effort exertion when the agent does not have negotiating power

When the principal is delegating the investment decision to an agent without negotiating power and effort exertion is not induced, she solves
the following problem:
( )𝛽 ( )𝛽
x x
max qL Y1 + (1 − qL ) Y2 (A.31)
{xi ,wi },i∈{1,2} x1 x2

11
M. Buso, M. Moretto and D. Zormpas Economic Modelling 102 (2021) 105586

subject to,
( )𝛽 ( )𝛽
x x
qL F1 + (1 − qL ) F2 ≥ 0 (A.32)
x1 x2

F1 ≥ 0 (A.33)

F2 ≥ 0 (A.34)

w1 ≥ 0 (A.35)

w2 ≥ 0 (A.36)
b(𝜃i ) xi
where Yi = − wi and Fi = 𝛿 + wi − I , i ∈ {1, 2}.
r
As the principal can solve the problem by choosing Fi = 0, i ∈ {1, 2} and as the objective function in (A.31) decreases in xi , wi , i ∈ {1, 2}, she
chooses the transfers and the investment triggers such that the ex-ante participation constraint{is binding.
} However, this means that the two ex-post
participation constraints will also be binding. From this we obtain the solution {ẋ i , ẇ i (ẋ i )} = xiFB , wFB
i
, i ∈ {1, 2}.
( )𝛽 ( ) ( )𝛽 ( ) ( )𝛽 ( )
In this case, effort is exerted when qH x∗ b(𝜃1 )
r
− w∗1 + (1 − qH ) x∗ b(𝜃2 )
r
− w∗2 is not smaller than qL ẋx b(𝜃1 )
r
− ẇ 1 +
x1 x2 1
( )𝛽 ( )
b(𝜃2 )
(1 − qL ) ẋx r
− ẇ 2 . Comparing the two we obtain
2
( )𝛽 ( ) ( )𝛽 ( )
x b (𝜃1 ) x b (𝜃2 ) qH 𝜉
− wFB
1
− − wFB
2
≥ . (A.37)
x1FB r x2FB r Δq Δq

Alternatively, this can be written as

𝜉
ΔqA ≥ qH (A.38)
Δq
( )𝛽 ( ) ( )𝛽 ( ) ( )𝛽 ( )
x b(𝜃1 ) x b(𝜃2 ) x b(𝜃1 )
where A =
x1FB r
− wFB
1
− x2FB r
− wFB
2
= R(x1FB , wFB
1
) − R(x2FB , wFB
2
) = W (x1FB ) − W (x2FB ), R(x1FB , wFB
1
)= xiFB r
− wFB
1
and
( ) ( )𝛽 (
xiFB
)
b(𝜃i )
W xiFB = x
+ 𝛿
− I , i ∈ {1, 2}. The equality R(x1FB , wFB ) − R(x2FB , wFB ) = W (x1FB ) − W (x2FB ) is attributed to the fact that F (x1FB , wFB )=
xiFB r 1 2 1
0, i ∈ {1, 2}.

A.3. Proof of Proposition 2

{ ( )}
When Ineqs. (A.4) and (A.5) are slack, the problem (A.1)–(A.7) has a unique solution: xi∗∗ , w∗∗
i
xi∗∗ , i ∈ {1, 2}.

A.4. Effort exertion when the agent has negotiating power

When the principal is delegating the exercise of the investment option to an agent with negotiating power, she cannot solve the problem
(A.31)–(A.36) choosing Fi = 0, i ∈ {1, 2}, as (A.32)–(A.34) are slack. In this case the principal’s problem is:
( )𝛽 ( )𝛽
x x
max qL Y1 + (1 − qL ) Y2 (A.39)
{xi ,wi },i∈{1,2} x1 x2
subject to:

w1 ≥ 0 (A.40)

w2 ≥ 0 (A.41)

or, equivalently,
[ ( )𝛽 ( )𝛽 ]
x x
max q L W 1 + (1 − q L ) W 2 − q L F1 + (1 − qL ) F2 (A.42)
{xi ,wi },i∈{1,2} x1 x2

subject to:

w1 ≥ 0 (A.43)

w2 ≥ 0 (A.44)
( )𝛽 ( )
b(𝜃i )
where Wi = x
xi r
+ x𝛿i − I , i ∈ {1, 2}.

12
M. Buso, M. Moretto and D. Zormpas Economic Modelling 102 (2021) 105586

The principal can dictate the investment threshold that maximizes the total value of the project Wi , i.e. xiFB , i ∈ {1, 2}. However, the transfer
will have to be higher than wFB i
, i ∈ {1, 2}, such that the agent can benefit from a project with positive NPV at the time of the investment
(Fi > 0, i ∈ {1, 2}).
Therefore, the contracts that the principal chooses when she}is delegating the exercise option to an agent with negotiating power and she chooses
{ ( )} { FB FB
not to induce effort exertion are ̌ ̌i ̌
xi , w xi = xi , wi + 𝜀+ , i ∈ {1, 2} where 𝜀+ > 0 is arbitrarily small.
( )𝛽 ( ) ( )𝛽 ( ) ( )𝛽 ( )
b(𝜃1 ) b(𝜃2 ) b(𝜃1 )
In this case, effort exertion is induced when qH x∗∗ − w ∗∗ + (1 − q )
H
x
− w∗∗ is not smaller than qL ̌xx ̌1 +
−w
x1 r 1 x2∗∗ r 2 1 r
( )𝛽 ( )
b(𝜃2 )
(1 − qL ) ̌xx r
̌ 2 . Comparing the two we obtain:
−w
2

𝜉
ΔR ≤ ΔqA − qH + Γ𝜀+ (A.45)
Δq
( )𝛽 ( )𝛽
x x
where ΔR was derived in subsection A.1.6, A was derived in subsection A.2 and Γ ≡ qL
x1FB
+ (1 − q L ) x2FB
> 0. Letting 𝜀+ → 0, the term Γ𝜀+
becomes negligible and Ineq. (A.45) can be written as
𝜉
ΔqA ≥ qH + ΔR . (A.46)
Δq

A.5. Welfare analysis

{ ( )}
The ex-ante total value of the project when xi∗ , w∗i xi∗ , i ∈ {1, 2} is chosen is given by the following expression
( )𝛽 ( )𝛽 ( )𝛽 ( )𝛽 (
( ) ( ) ( ) )
x x x x
qH Y1 w∗1 + (1 − qH ) Y2 w∗2 + qH F1 x1∗ , w∗1 + (1 − qH ) F2 x2∗ , w∗2 − 𝜉. (A.47)
x1∗ x2∗ x1∗ x2
{ ( )}
We have a similar expression when xi∗∗ , w∗∗
i
xi∗∗ , i ∈ {1, 2} is chosen.
Expression (A.47) can be written as
( )𝛽 ( )𝛽
[ ( ) ( )] [ ( ) ( )]
x x
qH ∗
Y1 w ∗
1
+ F1 x1
,
∗ ∗
w 1
+ ( 1 − q H ) ∗
Y2 w∗2 + F2 x2∗ , w∗2 − 𝜉 (A.48)
x1 x2
or as
( )𝛽 ( ) ( )𝛽 ( )
∗ ∗
x b (𝜃1 ) x1 x b (𝜃2 ) x2
qH + −I + (1 − q H ) + −I − 𝜉. (A.49)
x1∗ r 𝛿 x2∗ r 𝛿
{ ( )}
Taking the difference between (A.49) and its equivalent for xi∗∗ , w∗∗
i
xi∗∗ , i ∈ {1, 2} and keeping in mind that x1∗ = x1∗∗ , we obtain
( )𝛽 ( ) ( ))𝛽 (
⎡ ∗ ∗∗ ⎤
x b (𝜃2 ) x2 b (𝜃2 ) x2 x
(1 − qH ) ⎢ + −I − + −I ⎥. (A.50)
⎢ x∗ r 𝛿 r 𝛿 x2∗∗ ⎥
⎣ 2 ⎦
[( ) ( )]
𝛽 b
At this point, as x2∗ = x2FB < x2∗∗ and x2FB = arg max xy (𝜃2 )
r
+ y
𝛿
− I , this expression is positive. In other words, for the economy as a whole,
{ ( )} { ( )}
using xi∗ , w∗i xi∗ is always preferred to using xi∗∗ , w∗∗i
xi∗∗ , i ∈ {1, 2}.

Appendix B. Supplementary data

Supplementary data to this article can be found online at https://doi.org/10.1016/j.econmod.2021.105586.

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