Double-sided Opportunism in Infrastructure Investment

Abstract: Opportunism---either the government’s by changes in regulation and expropriation, or investor’s by deviations from expected investment, output quality, and price---is a powerful deterrent from potentially successful public-private partnerships with substantial sunk investments and welfare externalities. We show that the agents can overcome this double-sided hold-up by exchanging an exit (put) option for the investor and a bail-out (call) option for the government on the investor’s present value of outlays. The exit/bail-out options mechanism increases payoffs by countervailing deviations, and thus facilitates cooperation. We validate the model’s predictions in a laboratory experiment, and further show concurrent exit and bail-out options induce higher rates of partnership formation and sustainability.