Chapter EMC, Problem 2CYU

To determine

To discuss: The feature, that the contractor will bear the additional cost, if the cost increases than what was estimated along with the way it reduces the problem of moral hazard but forces the contractor to bear the additional cost.

Explanation of Solution

A moral hazard arises when an individual has more knowledge about their actions than others. This results in the falsification of incentives to apply or to take care of effort when someone else tolerates the costs of the lack of effort or care.

In the case of house construction, the contractor approximates the costs first and conveys that to the party and they both agree to the contract and the construction work begins thereafter. So, one of the features of construction contracts is that when it costs more than was initially projected to build a building, the contractor must engage the additional cost. Although this feature decreases the difficulty of moral hazard but it also forces the contractor to tolerate more risk than they would like. As there could be a circumstance when the contractor could not estimate the cost correctly or because the material cost has risen after the estimation. So, ethically this would be wrong if the contractor has to tolerate the additional cost just because the prices have changed with a change in times or just because estimating is just forecasting the cost and when you actually work in the field the scenario is totally different.

This feature reduces the problem of moral hazard as the contractor could not deceive and charge more cost for work that is not worth that cost but it also forces the contractor to bear the extra cost in case the estimation was not correct. So, this is wrong for the contractor.