Implications of Third Parties for Contract Design

By Marian Moszoro 

The literature on contracts has focused on transaction costs and contractual hazards, incentives and commitment, incompleteness, verifiability, and reference points, and relational contracting and the value of future business to explain contract features and the degree of discretion, but it has been largely agnostic about the implications of third parties for contract design.

Third parties are the agents interested, but not explicitly involved in a contractual relationship---e.g., watchdogs, minorities, advocacy groups, consumers, past and future transactors, and opponents/competitors to the contractees---who may challenge, either informally through the media or formally in a court, the legitimacy of the transaction, which typically carries an implicit (costly) demand for proof of the validity of the contracting process.

The role of third parties in public procurement has been highlighted by Spiller (2008) in his seminar paper “An institutional theory of public contracts: Regulatory implications” (NBER Working Paper 14152), and in Spiller (2013), “Transaction cost regulation” (Journal of Economic Behavior & Organization 89, 232--242).

Consider the following contractual setup:

a)    A contracting agent subject to periodical review,
b)    A contractor in a competitive market,
c)    Third parties with an interest in challenging the legitimacy of the transaction (e.g., competitors to either of them), and
d)    Multiple (and dispersed) principals and stakeholders that scrutinize the agent, 

and timing of the game:

At t=0, agent:

1. Receives project features and budget
2. Perceives threat of potential third-party challenges
3. Minimizes risks through bidding and contract design

At t=1, contractor:

4. Observes contract specificity
5. Less adaptability indicates higher contracting and implementation costs and therefore a higher price

At t=2, third parties:

6. Privately perceive the benefits from a potential challenge
7. Contract features affect third parties’ strategies whether to challenge the agent’s contract

At t=3, principals:

8. Observe the agent’s performance and challenges
9. Choose whether to keep the agent or punish her 

Third parties perceive the benefits of a challenge with a probabilistic distribution and subject to the principals’ sanctioning (e.g., through voting or court). The sequential equilibrium is that the agent will take some costly preventive action if that action makes it more difficult for the third parties to impose costs on the agent. The action may be the inclusion of contractual provisions that safeguard the agent, but do not increase the efficacy of the transaction at hand. This is so because the cost of the action is not entirely borne by the agent, but externalized to the principals and stakeholders (higher costs, lower profit).



Prevailing theories explain public contracts’ rigidity as an optimal choice to (a) foster price competition among firms for simple contracts, (b) account for higher investments at the project design stage for complex contracts, and/or (c) lower the risk of ex post renegotiation and alleviate a public agent’s hold-up problem by imposing ex ante rigid limits on her ability to renegotiate contract terms. In these theories, political risks are (tacitly) assumed away or considered insignificant. Third- party scrutiny highlight a channel---which complements extant theories---of greater rigidities in public contracts relative to private contracts in politically contestable markets.

Public contracts are open to challenge by third parties because of the public interest and the public monies involved. A whiff of corruption and a concern for the misuse of other people’s monies are all that is required to make a challenge to a public contract feasible. Although the awarding and performance of a public contract may be honest and legal, public agents fear politically motivated challenges (i.e., since the public at large cannot distinguish ultimately whether a challenge is honest or opportunistic, this distinction is irrelevant from the public agent’s standpoint, who treats every challenge as a political threat) and therefore will ex ante adjust the nature of contracts to limit those features whose probity may be questioned. These adjustments will imply more contract specificity in design and more rule-based and bureaucratic rigidity in implementation. Such contractual adaptations, however, come at a cost. Contractors’ perceptions of contracts’ specificity and rigidity will translate into higher prices and stronger compensation clauses. The contractual complexity and adaptation required to limit the potential for third-party challenges, whether opportunistic or not, make public contracting look “inefficient.”

A higher level of contract specificity and rigidity in public contracts can, therefore, be understood as a signaling device and political risk adaptation by public agents. However, it is not only civic-oriented legislation that limits public agents’ discretionary actions with “red tape,” but also that public agents hedge their exposure to the risk of third parties’ challenges through contract formalities and rigidities: Although they could rightly impose flexible terms in their favor, they opt not to, and thus signal probity and avoid potentially steep litigation costs.

The third-party opportunism framework is explanatory of settings in which a public agent faces a trade-off between contract efficiency and political hazards. The following comparative statics highlight some empirical implications (Moszoro and Spiller 2014):

a)     A private company can hire whoever it wants and a typical employment contract may simply say “follow the instructions of your principal,” whereas bureaucracies are subject to regulated hiring and lists of duties and responsibilities to reduce the risk of challenge of favoritism

b)    Small local governments face a lower likelihood of opportunistic challenge than larger government units and, subsequently, lower potential third-party opportunism costs. A public agent in a local community can therefore engage in more discretionary (efficient) contracts and incur lower transaction costs at lower contractual rigidity (which also in- creases the risk of corruption)

c)     Public agents employ costly external consultants and certified contractors to strengthen the objectivity of procurement processes and prevent third-party challenges that cooperation between public agents and private contractors has become collusive

d)    Fixed-price contracts do not provide adaptable risk-sharing mechanisms and may lead to an unintended increase in government payments. With closer third-party oversight and a fear of political challenges, however, public agents will prefer fixed-price contracts in settings in which cost-plus contracts could prove to be more efficient

e)     In the presence of political hazards, public agents will pursue public-private partnerships only in projects in which the expected gains from contract flexibility and better private management offset the increase in the costs of compliance required to keep political hazards at bay

f)     Public agents embed clauses (e.g., labor retention, modernization processes, future in- vestments, and other politically sensitive issues) and golden shares in privatization contracts to minimize political challenges of “cream skimming”. Such privatization clauses, however, curb the company’s governance and consequently lower its selling price and revenue to the public treasuries (i.e., analogously to a high price for a public procurement)


Further Developments

Spiller’s framework combines third-party oversight and transaction costs to explain the apparent inefficiencies in contract design. High ex ante payment volatility or ex post flexibility in implementation triggers drawbacks that lead to contract failures or costly adaptations by agents subject to scrutiny. Therefore, such contracts cannot be directly compared with two-sided impersonal private contracts, but instead should be compared with analogous con- tracts in similar institutional environments and be able to pass Williamson’s “remediableness criterion,” which holds that “an extant mode of organization for which no superior feasible alternative can be described and implemented with expected net gains is presumed to be efficient” (Williamson 1999, 316; the emphasis is in the original). In other words, efficiency analysis should factor in economic and third-party transaction costs.

The consideration of third parties raises a number of testable predictions and interesting speculations. A formal model of how actual contract terms affect the contract challenge process might yield new insights. Alternatively, a signaling model might be built around either public agent probity or project characteristics that only the agent can observe. Similarly, the differences in third-party challenger motives discussed (opportunism versus public interest) might also be exploited. Among other things, the latter could allow consideration of different welfare implications of rigidity: Whereas added rigidity is unequivocally bad if it prevents meritorious challenges (e.g., from publicly interested parties countering corruption), rigidity that deters rent-seeking challenges (from opportunistic competitors trying to “steal” the contract) may actually be beneficial.



Moszoro, M. W. and P. T. Spiller (2014). Third-party opportunism and the theory of public contracts: Operationalization and applications. In E. Brousseau and J.-M. Glachant (Eds.), The Manufacturing of Markets: Legal, Political and Economic Dynamics, Chapter 11, pp. 229–252. Florence: Cambridge University Press.

Spiller, P. T. (2008). An institutional theory of public contracts: Regulatory implications. NBER Working Paper 14152, National Bureau of Economic Research. 

Spiller, P. T. (2013). Transaction cost regulation. Journal of Economic Behavior & Organization 89, 232--242.