Risk Taking And Our Renovation Contract

One of the intellectually interesting things to me about this house renovation experience has been our relationship with the plaster and wood renovator. He and his team have done a great job with our walls, many of which needed some serious TLC, and the wood looks amazing. The economic side of it, though, has not gone so well for either side, and from a new institutional economics/transaction cost perspective, it’s instructive.

We started out in late May with a fixed price contract for a certain number of items, to be completed by a certain time. Now, you know and I know, and I’m sure he knows, that a fixed price contract means that the contractor bears all of the risk of whatever is going on in those walls. In this case, once he stripped off the two layers of paint on top of the two layers of wallpaper in the living room, stairwell, and two front bedrooms, the bedroom walls needed more care and attention than he had anticipated. Fixed price contracts do not allow the flexibility to incorporate and adapt to unforeseen contingencies.

We had a contract, so I could have told him tough, he based his estimate on a probabilistic idea of how much work would be involved but the work was further out in the right tail of the distribution. Putting it that way casts the problem as one of ex ante risk sharing, where there is some probability distribution over the amount of work that the walls were likely to need. He made his ex ante assessment, gave us a quote, there you have it.

But he, naturally, started complaining about how much work the walls required, and how the electrician fishing for outlets degraded the plaster even further, so they were having to clean up after him, etc. etc. Then he did something clever: he showed me how easy it would be to strip the old varnish off of the wood, instead of just the cleaning and tung oil and polyurethane for which we had originally contracted. On balance, it wouldn’t require a whole lot of additional work.

So mid-project we renegotiated. I agreed to an addendum, and the amount I agreed incorporated both additional funds to compensate for the additional plaster work and additional funds to strip and stain the wood.

Notice the important economic function of this renegotiation: it enabled him to share some of the risk with us. And because he and his team do good work, we were willing to take on some of it. And he knows that we are well enough informed about the market that we aren’t suckers, so it’s a split, not a push of all of the ex post cost on to us. He’s eating some of that cost, as one does when one runs a business.

Now that we are in the house there are three unfinished items from the original contract. What will be interesting is to see how he will handle that, because he’s already arguing that even with the addendum contract he’s losing his shirt. Will we hold him to specific performance of the items stipulated in the original contract? Or will we just drop it? One of them is really important to me: power washing the basement with TSP. The other two are less important.

This experience reinforces the belief that I already had about the futility of the game theorist’s quest for renegotiation-proof equilibria. Sure, on the computer screen renegotiation-proof-ness is a dandy equilibrium concept. But in real-world transactions, even in this simple environment where I’ve cast the problem as one of risk (i.e. known probability distribution) and not uncertainty (i.e., no known probability distribution), the ability to engage in ex post renegotiation may actually make both parties better off, relative to the real alternatives of either fixed price contracts or billing customers based on time and materials.

In fact, my husband said as much to our contractor. Apparently he was saying that if he had it to do over again, he would have proposed a time-and-materials contract to us instead of a fixed price contract, which would obviously have eliminated all of his risk but put it all on us. My husband pointed out to him that we would not have accepted his offer on such open-ended terms with incentives that are so prone to abuse (moral hazard, in this case).

The ability to renegotiate mid-stream allows two parties to share the ex post cost and is an institution that enables more, and more valuable, transactions to occur than would otherwise. Because of it we had them do more than we would have on a time-and-materials contract, and we are very happy with the result of what’s actually been done. There’s the value creation on the consumer side. The contractor and his team get paid, and while they didn’t get rich on our job, they did cover costs and they didn’t have anything else in the pipeline, so their opportunity cost was low. There’s the value creation on the producer side.