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September 20, 2007
Is there a natural equalibirum?
Marginal revolution is talking about contractors and what strategies you can use to control costs in the posting Broken Buildings, Busted Budgets. This is all by way of a review of a new book, Broken Buildings, Busted Budgets: How to Fix America's Trillion-Dollar Construction Industry.
My thoughts, which are straight out of first year economics, is that if the both the owner and the builders do not know the true cost of building the project, which can happen if you are redoing a bathroom or if you are building a sky scraper, then it becomes a sensible matter of who should absorb the risk. If the contractors are more risk averse then the owners are, the amount of compensation they require to take on that risk is higher than the owner would pay them to take it. That would make no-overrun contracts undesirable even if you could fix the agency problem.
Whether you should have a no-overrun contract would seem to depend on the size of the differences in risk aversion and the variance of cost estimations. So what are the relative sizes of the the agency and the cost estimation problems? I don't know.
In the case of a home project, the contractors are usually much poorer than their customers, so it would be reasonable to assume they are comparatively more risk averse. But most homeowners know next to nothing about what high quality construction looks like. And even if the visible stuff is well constructed, the hidden stuff might be junk that takes a while to reveal itself as such.
In a big project, the contractors have insurance, and are usually rich themselves. The customers are usually rich and experienced in the building process, so are well positioned to carefully evaluate the work they receive. Therefore, it might be better on the high end to have tighter contracts to ensure a highly focused mind in the cost estimation stage.
Posted by OneEyedMan at September 20, 2007 7:33 AM
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