How Game Theory Explains the Pitfalls of Project Contracting (And How to Fix Them)
Chuck Centore | President of PM&E
Theoretical Insights: Game Theory and Contractor-Owner Dynamics
Game theory provides a framework to analyze strategic interactions between owners and contractors, who often have interdependent outcomes. Each party can choose to act competitively or cooperatively. A well-known model, the Prisoner’s Dilemma, illustrates how rational players acting in self-interest can end up worse off than if they had cooperated.
This dynamic is common in major project execution: owners and contractors protecting their own interests—whether by maximizing individual gain or withholding critical information—can lead to suboptimal project outcomes. For example, an owner squeezing a contractor’s profit margin or a contractor cutting quality to save costs can ultimately jeopardize project success.
Robert Axelrod’s research on game theory and the evolution of cooperation demonstrates how collaborative strategies can emerge even among self-interested players in repeated interactions. His iterative Prisoner’s Dilemma tournaments revealed four key traits of successful strategies:
1. Be Nice – Initiate cooperation and avoid unnecessary conflict.
2. Be Retaliatory – Respond decisively to defection to prevent exploitation.
3. Be Forgiving – Resume cooperation when the other party returns to fair play.
4. Be Clear – Maintain transparency to foster trust and predictability.
In contracting, an owner who pays on time and a contractor who meets commitments build mutual goodwill. If one party breaches trust, the other can respond within contract terms (e.g., penalties, withheld payments). However, if the issue is corrected, cooperation should resume to keep the project on track.
Another key insight from Axelrod is the "shadow of the future": cooperation is more likely when parties expect ongoing interactions or value their reputation for future projects. Long-term alliances and repeated collaborations shift the equilibrium toward cooperation, reducing the adversarial nature often seen in one-off, lowest-bid contract arrangements.
Designing Contracts for Cooperation
To foster collaboration and avoid adversarial contracting, structure contracts like repeated games where cooperation is rewarded over time. Key strategies include:
✔ Reciprocity and Tit-for-Tat – Start cooperatively and mirror behavior. Reward good performance with fair contract adjustments or future work while responding proportionally to opportunistic actions. Avoid unnecessary conflict but return to cooperation once trust is restored.
✔ Align Incentives – Design contracts so that what benefits the project also benefits both parties. Use incentives like bonuses for early completion, shared savings for cost efficiency, and performance-based rewards. Avoid structures that encourage cost inflation or misaligned priorities.
✔ Encourage Long-Term Relationships – Promote repeated interactions by considering contractor performance in future contract awards. Preferred contractor programs and multi-project alliances encourage sustained cooperation and reduce short-term opportunism.
✔ Transparent Communication – Reduce information asymmetry by sharing project data openly through regular updates, joint progress reviews, and clear change management processes. Transparency builds trust and discourages contract manipulation.
✔ Trust with Safeguards – While trust is important, rely on well-structured contracts to ensure cooperation. Establish clear dispute resolution processes, aligned incentives, and transparent expectations to reduce reliance on goodwill alone.
✔ Fair Risk Allocation – Assign risks to the party best equipped to manage them. Excessive risk transfer often backfires, leading to inflated costs, claims, or project failure. Collaborative risk management improves outcomes.
✔ Simplicity and Clarity – Avoid overly complex contracts with ambiguous terms or excessive penalties. Clearly define responsibilities, incentives, and key metrics to ensure all parties understand and adhere to the contract.
By applying these strategies—reciprocity, aligned incentives, long-term engagement, transparency, fair risk sharing, and clarity—contracting can shift from a zero-sum game to a cooperative, value-driven approach that benefits all parties.
Contract Models Through a Game Theory Lens
Different contract models shape distinct strategic interactions between owners and contractors. Below, we analyze Lump Sum, Cost-Plus, and EPC contracts through game theory principles.
Lump Sum (Fixed-Price) Contracts
The contractor agrees to deliver a project for a fixed price, commonly used in Design-Bid-Build procurement for well-defined scopes.
Strengths: Strong incentive for cost control—every dollar saved increases profit, while overruns reduce it, driving efficiency.
Weaknesses: Adversarial tendencies arise when the scope changes, leading to claims and disputes as contractors seek to recover margins.
Strategic Implications: Works best when the scope is well-defined and relationships foster cooperation. Clear contract terms and efficient change management mitigate conflicts. Hybrid approaches, such as cost allowances for uncertainties, can prevent extreme risks.
Cost-Plus (Cost-Reimbursable) Contracts
The owner reimburses the contractor’s actual costs plus a fee, with variations like fixed fees, incentive fees, and guaranteed maximum price models.
Strengths: Encourages transparency and collaboration, reducing adversarial behaviors. Ideal for uncertain projects where flexibility is needed.
Weaknesses: Risk of inefficiency—without strong incentives, contractors may lack motivation to control costs or meet deadlines.
Strategic Implications: Incentive mechanisms like shared savings or target cost agreements align contractor interests with project success. Audit rights ensure accountability without eroding trust.
EPC (Engineering, Procurement, Construction) Contracts
A single contractor delivers a complete facility for a fixed price and schedule, commonly used in large capital projects.
Strengths: Simplifies owner coordination, encourages holistic optimization, and incentivizes cost efficiency under a fixed price.
Weaknesses: High contractor risk can lead to disputes, claims, cost-cutting, or even default if overruns are severe.
Strategic Implications: Risk-sharing mechanisms, phased contracting, and balanced incentives improve cooperation. A two-phase EPC (reimbursable design phase followed by fixed-price execution) reduces information asymmetry and pricing risks.
This analysis highlights how contract structures shape incentives and behaviors, influencing project outcomes.
Key Takeaways for Decision-Makers
Rigid contracts create conflict. Instead of transferring risk, they create cost inflation and litigation.
Game Theory Principles Can Transform Contracting: Understanding strategic interactions can prevent adversarial dynamics. Game theory teaches that cooperation outperforms confrontation when structured correctly.
Incentive Structures Matter: Contracts should align all parties’ success with project success. A contract should make fair play the most profitable strategy for all parties.
Transparency is Essential: Open-book contracting and clear communication foster trust.
Long-Term Relationships Improve Outcomes: Repeat engagements encourage cooperative strategies.
Avoid Zero-Sum Mindsets: Contracting should be designed as a positive-sum game to ensure mutual benefit.
Conclusion
Contracts don’t execute projects—people do. The best contracts aren’t weapons but tools for alignment and problem-solving. Applying game theory can help project leaders create agreements that ensure collaboration, not confrontation, is the winning strategy.
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