THEORY OF BEHAVIOURAL ECONOMICS

AND INNOVATIVE WAYS TO OVERCOME

PROBLEMS IN PROJECT PROCUREMENT
An Article
Prepared by

Prof.(Dr.) Ajit Patwardhan

1
THEORY OF BEHAVIOURAL ECONOMICS &

INNOVATIVE WAYS TO OVERCOME TO

PROBLEMS IN PROJECT PROCUREMENT

Introduction:

This year, the Nobel Prize for Economics, has been awarded to Prof.
Richard Thaler of Chicago University, for his contribution to
Behavioural Economics. In the press statement, the Royal Swedish
Academy of Sciences described his contribution as under:

“Thaler has incorporated psychologically realistic assumptions into

analyses of economics decision- making. By exploring the
consequences of limited rationality, social preferences and lack of
self-control he has shown how these human traits systematically
affect individual decisions as well as market outcomes….

“In total, Richard Thaler’s contributions have built a bridge between

the economic and psychological analyses of individual decision-
making. His empirical findings and theoretical insights have been
instrumental in creating the new and rapidly expanding field of
BEHAVIOURAL economics, which has had a profound impact on many
areas of economic research and policy.

Reason for raising this issue:

Before proceeding further on the details of his theory and

applicability of his academic work, this writer intends to share with
readers, the reason why, this article is being written, in the context
of Project procurement and its Execution.

It is a well known fact that large Infrastructure Projects awarded by

Public bodies in India and other countries are manyatimes delayed
resulting into substantial time and cost overrun. Sometimes these
2
projects are stalled for years causing serious losses to the Country
and the Economy. Many External and Internal factors are responsible
for this situation. Whatever the nature of problems, the biggest
hurdle in settling those issues is the inability of two parties to the
Procurement contract to interact and resolve the problems and
reach amicable solutions.

Is it possible that two parties to such Contracts do not see the way
out, because of their irrational BEHAVIOURAL attitude, rather than
lack of possible remedy to the problems faced by them. Studies
conducted by many experts about such disputed cases in this field,
suggest that not so rational approach, based on unwarranted pride
and prejudice alongwith adversarial nature of relationship between
the two parties might be responsible for this dilemma.

Applicability of the theme:

If we try to apply theory of Nobel Lauret Prof. Thaler about human

irrational behaviour in Economic decisions making, to above Projects
related problems, you get surprised by the relevance of his many
ideas in this context. This writer would like to show the connection
between Prof. Thaler’s and other experts’ ideas, and the problems
faced in Project execution, to establish the relevance of these
concepts and possible remedies, based on these theories from
Behavioural Economics.

To connect the issues properly, Prof. Thaler’s ideas are first quoted
and its applicability to Project contract issues are then examined.

Idea of Limited Rationality:

Prof. Thaler developed the theory of mental accounting, explaining

how people simplify financial decision- making by creating separate
accounts in their minds, focusing on the narrow impact of each

3
individual decision rather than its overall effect .He also showed how
aversion to losses can explain why people value the same item more
highly when they own it than when they don’t a phenomenon called
the endowment effect. Prof. Thaler was one of the founders of the
field of Behavioural finance, which studies how cognitive limitations
influence financial markets.

This concept of limited rationality can explain, why various claims or

disputes are not seen as a whole, but a separate & limited view is
taken of each claim, rather than its overall effect. In many disputed
cases, it is noticed that of a party to the dispute concedes their
liability in a particular issue, other party is also willing to concede
their deficiency on the other issues, but it is resisted by parties due
sense of actual loss then rather than likely future gain, due to sense
of limited rationality.

Idea of Social preferences:

Mr. Thaler’s theoretical and experimental research on fairness has

been influential. He showed how consumers’ fairness concerns may
stop firms from raising prices in periods of high demand, but not in
times of rising costs. Thaler and his colleagues devised game, an
experimental tool that has been used in numerous studies to
attitudes to fairness in different groups of people around the world.

This principle of fairness if applied by the Client to its Contract

structure can result into a very competitive prices being quoted by
the Contractors, because of balanced terms and conditions. It is a
common experience that fair & balanced contracts can attract
competitive prices in International bidding of Infrastructure projects,
resulting into win-win situation. However this is resisted by Client
writing the contract, to protect only his risks and interests.
4
Lack of self- control:

Mr. Thaler has also shed new light on the old observation that New
Year’s resolutions in can be hard to keep. He showed how to analyse
self-control problems using a planned-doer model, which is similar to
the frameworks psychologists and neuroscientists now use to
describe the internal tension between long-term planning and short-
term doing. Succumbing to short term temptation is an important
reason why our plans to save for old age, or make healthier lifestyle
choices, often fail. In his applied work, Mr. Thaler demonstrated how
nudging a term he coined, may help people exercise better self-
control when saving for a pension, as well in other contexts.

This is a well known principle, followed in our personal life, is equally

applicable to Life cycle approach in Project Management. Earlier
many projects were awarded on the basis of quotation for only
construction. Over period of time, Design Build & Commission
project became more popular. But in recent times, when clients from
Public Bodies, have started taking a long term view of projects by
adopting for Design, Build Maintain & Operate, has resulted into
savings & cost reduction over project life cycle in the long run.
However this approach is not well settled in all project awards,
resulting into apparent lower contract prices in the early stage, but
much higher overall cost over the project life cycle.
Above quick observations are made to show connection between
ideas of Behavioural Economics propagated by Prof. Thaler & other
experts with Project execution. However, the readers of this article
might seek more cohesive view for proper understanding. Hence,
this writer has decided to present project life cycle flow, touching
upon issues, which are affected by imperfect Behavioural attitude of
contracting parties resulting into unhappy and damaging outcomes.

5
Impact of Irrational decisions & Innovative Remedies to overcome
them during Stages of Project Life Cycle:

Stage 1 : Concept & Feasibility :

Project concept is initiated with the input from planning dept.
of Public bodies based on their approved objective and budget
allocation. The Project Authority prepares the scope of the project
scheme based on the concept of the project with design outline from
Technical dept.
Non Rational choices & outcome:
a) The overall Price limit for the project is decided by budgetary
allocation to the Project from the Funds available in the
planned period, sometimes unconnected with the likely
reasonable cost estimate of the proposed project, creating
pressure on the scope and specification of the Project.
b) The time of completion is chosen to suit Public expectations
and political compulsions, rather than within reasonable time
frame. Contractor accepts such unrealistic time frame to get
the business resulting into delays and penalty disputes.
Rational Review & Remedies :
a) Project concepts need to be expanded ,to work out realistic
initial cost estimate of the project, before approving the
budgetary provision. Some contingency amount needs to be
added to this budget to take care of bidder’s response and
market based assessment of project cost.
b) The time of project completion can be reasonably assessed by
Employer’s project team which should not be changed for
political reasons or public expectations. Rather the realistic
project completion time should include time margin for
unexpected delays likely to be faced by the Infrastructure
projects, due to many Internal/ External factors.
6
Stage 2 : Scope & Tender Preparation:
The Procurement Authority issues Tender documents, by
attaching standard commercial & contractual terms to the scope of
works decided by the Project planning and Technical departments.
Non Rational choices & outcome:
a) The commercial & contractual terms are adopted from
ongoing standard practices (for decades) without examining
its relevance or the need for review with changing business
environment.
b) Due to pressure from International Contractors some minor
improvements are made to satisfy the expectations of
Funding agencies, but the improvements are neutralised
through provisions in particular conditions.
Rational Review & Remedies :
a) The participating Bidders/ Contractors and professional
bodies can be asked to review the standard contract
conditions & make suggestions for improvements. Joint
committee of stakeholder, can study these suggestions &
make recommendations for fine tuning the Standard
Contract conditions ,adopted by Public Bodies.
b) Any Special or Particular conditions provided by the
Employer cannot be against the principles of General
Conditions of Contract. Any specific conditions provided in
the contract, should be there to add or explain the General
Condition applicable to particular project or to cover issues
beyond Standard Conditions of Contract, which need to be
clarified.
Stage 3 : Tendering & Bidding :
The usual Tendering process is carried alongwith the Site visits,
Prebid meetings with Contractors & clarifications are issued for the
points raised by participating Contractor.
7
Non Rational choices & outcome:
a) Site information provided by Public bodies is not adequate and
contractors are required to satisfy themselves with all the
needed details, which they cannot manage by short duration
site visits.
b) Hundreds of queries raised by Contractors about the scope of
work are not sufficiently clarified with standard reply about the
need for “study of whole tender documents in proper manner”.
Rational Review & Remedies :
a) Site information provided by Employer need to be accurate,
because awareness of project ground realties is likely to be
quite high with their project team. The bidders can only
familiarise themselves with risk associated site conditions at
project location. Both parties can agree upon suitable remedies
for unforeseen ground conditions, discovered afterwards.
b) The Scope of projects needs to be well defined by the Employer
to minimise, the queries raised by bidders before bidding. Also
genuine doubts raised by the bidders need to be addressed in
details, without avoiding the responsibility about the certainty
& clarity of scope.
Stage 4 : Award of Contract:
The project is awarded to the lowest bidder when he makes an
unqualified offer without any conditions or assumptions about
the scope of work and withdrawing any exception suggested by
him about scope or contractual terms and conditions.
Non Rational choices & outcome:
a) It is common knowledge that contractor withdraws any
issues raised by him, to avoid getting disqualified and loosing
present & future business though his real concerns are not
addressed.

8
 b) While as the choice of scope and main features of the
project are decided by Public body, the contractor is
required to take full responsibility of design and
performance.
Rational Review & Remedies:
a) Though the Contract can be awarded only when the
unqualified offer is made by the bidder. But forcing the
withdrawal of any conditions to the offer by bidder, can later
on be treated as unfair compulsion or undue influence by
the Employer resulting into Contract of Adhesion, which can
be avoided by handling bidder’s assumptions sensibly before
award of Contract.
b) When features of the Project are chosen by Employer, he
must remain responsible for Choice of his requirements and
only balance issues of the plants design need to be attended
& guaranteed by Contractor.
Stage 5 : Design & Engineering:
The successful Contractor submits Design & Detailed
Engineering drawing for Client’s review and proceeds with
execution after approval.
Non Rational choices & outcome:
a) Though contractor is responsible for developing designs &
drawings fit for purpose, his design is reviewed with
substantial comments for improvement without its
impact on price and time of completion.
b) Even after compliance to the design review comments
made by Client the Contractor is fully responsible for the
project performance outcome.
Rational Review & Remedies:
a) Though the Contractor is responsible for his design details,
if his choices are asked to be changed during Employer’s
9
 approval, he should be allowed to seek cost, review if
design details are changed to suit Employer’s preference,
despite being adequate as per Contractor. This will
compensate the Contractor for changes and give freedom
to Employer to pursue their choices.
b) Whenever Employer pursues his design choices during
approval, it is only fair that he accepts the responsibility of
those preferred changes & relieve the Contractor of his
design obligation to that extent.
Stage 6 : Planning & Execution:
The Execution plan made by Contractor is reviewed &
approved by Clients with comments for implementation. The
Contractor is required to mobilise his resources to achieve the
objective and to attend promptly to decisions and instructions
given by the Client.
Non Rational choices & outcome:
a) Normally Contractor is unable to mobilize as per promise
made by him since those are unrealistic and his resources
are still engaged in some other projects under
completion.
b) Client expects complete mobilisation in short time despite
site handling over by him is not completed. This is
expected because release of full advance is connected
with full mobilisation.
Rational Review & Remedies :
a) The Contractor needs to honour his commitment to
mobilise as promised in the proposed schedule. His failure
to mobilise as planned, needs to be treated strictly either
by withholding the part of advance payment or by setting
a side some amount from payable bills for delayed
mobilisation by clear cut contractual provision.
10
 b) The Contractor cannot be forced to carry out full
mobilisation, if his resources cannot be gainfully employed
at site. The Contractor needs to be allowed to mobilise in
proportion to the available site portion for execution.
Stage 7 : Revised Planning & Execution :
It is clearly expected that whenever project is delayed
compared to its schedule, the revised plan has to be submitted
by Contractor to catch up with the original schedule, without
ascertaining the reasons for the delays.
Non Rational choices & outcome:
a) The Contractor is required to revise the planed schedule
to catch up by mobilising additional resources without
any settlement about the increased cost or who should
bear, what share of cost for the delays.
b) Delays due to reasons beyond the control of contractor
are allowed, but not compensated since, client is also not
responsible for those delays.
Rational Review & Remedies :
a) It will be appropriate to make provision for establishing
the reasons for delays and compensation for accelerating
the work, if not caused by Contractor. It may be necessary
to provide for the instruction by Employer for
Acceleration, if so desired by him.
b) Whenever Delays are caused by reasons beyond the
control of both the parties, the Employer may grant the
necessary extension, but may choose not to compensate
Contractor and not insist upon acceleration of work.
Stage 8 : Change Requests & Variation order:
After some initial period of work, need for changes in
scope of work arise due to various reasons. Despite variation

11
 procedure provided in the Contract, changes related Variation
orders are delayed or unresolved.
Non Rational choices & outcome:
a) There is always some disagreement about the change
request being part of original scope of work or genuine
addition to original scope because of lack of certainty
of inclusion at initial stage.
b) In Design, Build Contract models this is supposed to be
Contractor’s responsibility, which is resisted by him, by
claiming that it is an addition to the original scope
resulting into unresolved claims.
Rational Review & Remedies :
a) The Change requirement by Employer in scope should
generally be paid by him, based on the clearly provided
provision for its valuation. The Change suggested by
Contractor may not result into Change –order. Unless it
can be shown that it is due to unavoidable
circumstances about the material or supplier
capabilities in the market beyond his control.
b) But for Design Build projects, any suggestion for
improvement in Design or processes by Contractor
should not result into time & cost increases. Also why
any party is seeking change needs to be ascertained.
Stage 9 : Claims & Dispute Resolution:
When claims are raised, but cannot be settled due to
disagreement, proper mechanism is generally provided in the
Contract, consisting of Engineer’s determination and/or
Dispute Board’s decision.

12
Non Rational choices & outcome:
a) The Engineer’s determination though provided is rarely
invoked due to lack of faith in the determination by the
Engineer, who is appointed and paid by the Client.
b) Dispute Board mechanism does provides decisions on
disputes, but never honoured by parties . The affected
party prefers Arbitration under Law; rather than trusting
the Dispute board decisions.
Rational Review & Remedies :
a) The provision for Determination by Engineer if stated in
the contract must be applied, despite Contractor’s or
other party’s reluctance to go for it. In any case both
parties have freedom to challenge it later on before
Dispute Board or even afterwards in Arbitration.
b) In case of Dispute Board related provisions also, the
process must be conducted and honoured by both the
parties, since they are free to challenge it afterwards in
Arbitration. This is essential to avoid stoppage of work,
which may happen due to disagreement about the
decision of the Dispute Board.
Stage 10 : Arbitration & Litigation :
When disputes are brought to Arbitration, due process is
started to resolve them. Though the Arbitration takes long
time, it is supposed to end with an award on disputed matters.
Non Rational choices & outcome:
a) The Arbitration award though final and binding, is
challenged & bought to the Court on technical ground
or on partiality & bias to avoid implementation of the
award.
b) The Court, though not supposed to easily admit the
challenge to the Arbitration award, readily agrees and
13
 admits the cases for review, which takes years for
conclusion, damaging the interests of the affected
party, mainly the Contractor.
c) The Contractors are asked to provide Bank Guarantee
to get 75% amount released pending Litigation, which
they cannot manage because of financial constraints.
This Project life cycle review gives the impression that the
non-rational behaviour originates mainly on the Client side. In
reality, the Contractor is also responsible for accepting non-
rational conditions and decisions and making unrealistic
promises for getting the business. They also treat their Sub-
contractors with quite unfair provisions in the sub- contracts,
knowing that such irrational conditions will not work.
Rational Review & Remedies :
a) The issues on which Arbitration award is challenged can
be reduced or minimised by creating framework of
Institutional Arbitration. This can happen only by Govt.
initiative. But once such National structure is created ,
the Institutional Arbitration can be made binding on all
the parties.
b) The issue of further Legal challenge to the Arbitration
award still remains. However the delays of Court process
remains an issue in many countries. However creation of
Commercial courts, established by the Govt. can
improve the process of speedy trial and resolution.
Commercial courts in some countries have shown
encouraging results.
c) The question of Bank Guarantee for release of Award
money is an India specific issue, which might ease out if
Institutional Arbitration and Commercial Courts are

14
 established for speedy and just resolution of Contract
disputes.
Conclusions and Way forward
After reading about these Non Rational Choices listed here, one
keeps wondering, if some remedies exist to overcome these
irrational outcomes.
Fortunately Prof.Thaler & other Behavioural Economists have
suggested remedies to overcome this dilemma. In his famous
book ‘Nudge’ co-authored with Prof.Sunstein. Quite a few
Nudging ideas are suggested for managing these non-rational
financial decisions. If there is basic consensus among all the
stakeholders, that, there are number of non-rational decisions ,
taken in Infrastructure project execution and need rational way
out, then we can nudge all the interested parties towards, fair
and balanced outcomes saving country and the economy
tremendous time & considerable costs, for the benefit of
common citizens.
This question is not only about who is responsible for non-
rational choices and outcomes, but about if something can be
done by applying Behavioural theories proposed by Nobel
Laureate & other experts. Luckily in many countries the
remedies suggested by them are being adopted in deciding
Public policies, towards better outcome. Simply put, concerned
Govts. And Public authorities can be nudged towards right
remedies, if all accept that many policy decisions are taken with
restricted or limited rationality, if not by completely irrational
manner.
These realistic suggestions may become quite simple but
innovative remedies for project procurement.

15