Mitigating Bilateral Dependency

Technical Notes

Nov 24, 2009 — Neil Boyle

Bilateral dependency arises as a result of the fundamental transformation of incentives that occurs after contracts are signed and the strong incentives that are posed by autonomous traders in a large number competitive demand arrangement are conflicted with having to deal with the small number supply relation vis a vis the counterparty. In order to mitigate the respective hazards created by the risk exposure of durable transaction specific assets, both parties to a contract must create an effective bilateral trading relation; otherwise maladaptation will set in. Mitigation involves negotiating safeguard mechanisms or institutions to prevent maladaptation due to the unrelieved hazards of bilateral dependency. Autonomous bilateral trading of hybrids (i.e., PPP infrastructure projects) is fraught with hazard due to bilateral dependency occasioned by misalignment.  When misalignment goes uncorrected, it turns into maladaptation. Mitigation occurs by agreeing to (1) an administrative structure that addresses the non-sequential decision-making that arises; (2) a contractual provision that addresses the need to mutually solve (and share costs and benefits) unforeseen problems when they occur; and (3) terms and conditions for autonomous bilateral trading on the basis of mutuality of interests, including addressing the issue of expropriation hazards of equity.

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