※ The provided materials below have been translated into English using computer-assisted translation.

The incorporation of a Price Adjustment Clause (PAC) in contracts, allowing for delivery price adjustment in line with fluctuations in raw material costs, facilitates risk sharing between the prime contractor and subcontractor.

Amidst considerable price uncertainty, this proves advantageous for both parties. However, mandatory PACs could compromise economic efficiency and, if misused, expose subcontractors to financial losses. Thus, policy design must integrate economic incentives to mitigate these issues.


I. Progress on the Adoption of Price Adjustment Clause

Amplified volatility in raw material prices, catalyzed by a succession of external shocks including the Covid-19 pandemic and the Ukraine crisis, have precipitously inflated production costs. This turmoil has rendered a considerable erosion of profit margins, particularly for subcontractors functioning under fixed price contracts. Korea, in 2009, instituted a legislative provision allowing subcontractors to apply for price adjustments with prime contractors, in the event of prodigious fluctuations in the costs of production inputs, pursuant to Article 16(2) of the Fair Transactions in Subcontracting Act and Article 22(2) of the Act on the Promotion of Mutually Beneficial Cooperation between Large Enterprises and SMEs. Despite several legislative refinements, the efficacy of the provision remains under scrutiny, with critics highlighting the pronounced power disparity between main contractors and subcontractors, which often inhibits suppliers from asserting their rights due to potential adverse commercial repercussions, such as refusals to deal by the prime contractor.

In response, the government is crafting strategies for the integration of a mandatory Price Adjustment Clause (PAC) within the terms of subcontracting and consignment agreements. Once specified conditions are met, the PAC mandates the automatic reflection of an increase in raw materials costs onto the price of delivered goods, thus sharing the risk of price volatility between the parties involved. This risk sharing measure aims to alleviate management challenges experienced by subcontractors, predominantly small and medium enterprises (SMEs).

In 2022, the Ministry of SMEs and Startups unveiled a six-month pilot project, the 'Delivery Price Adjustment System', starting in September (MSS, Aug. 11, 2022), followed by the release of a standardized subcontract and consignment agreement inclusive of the PAC, jointly formulated with the Korea Fair Trade Commission (KFTC and MSS, Aug. 12, 2022). The ensuing provisions detail essential terms, such as raw material price indices, price adjustment requirements and cycles, and adjustment ratios, among others. Certain specifics are earmarked for future negotiation between contracting parties. If stipulated conditions are satisfied, the delivery cost in the contract will automatically incorporate price changes using a predetermined formula. The KFTC further incentivized the adoption of PAC by granting additional points in government tenders and reduced penalty points under the Fair Transactions in Subcontracting Act. There have been bipartisan efforts to adopt the clause, but the bills submitted to the National Assembly vary significantly in scope and details, for instance on subject matters and the required conditions for price adjustment. Proposals for the incorporation of the PAC are currently a matter of heated political debate, with variations in the scope and minutiae of the bills submitted to the National Assembly. 

Public opinions regarding the PAC are polarized and numerous studies are underway to elucidate current dynamics and potential outcomes (Kim, 2021; You, 2022; Choi, 2018; Korea Economic Research Institute, June 2, 2022; Korea Fair Trade Commission, 2022.5.15; Korea Federation of SMEs, July 2021., etc.). The ongoing debates and controversies underscore the importance of encompassing diverse viewpoints in future policy-making processes, bearing in mind considerations of economic effectiveness, legal ramifications, and social consensus for mutual prosperity. The present study delves into the economic implications and potential effects of price adjustment.


II. Economic Implications of Price Adjustment

The uncertainty inherent in forecasting raw material prices engenders significant challenges for contracting parties seeking to formulate subcontract or consignment agreements. Precise prediction of future prices facilitates their reflection in the agreed delivery price; however, in circumstances of considerable uncertainty, these parties must engage in negotiation concerning the delivery price and contract duration, considering the associated risks. Short-term contracts, or those featuring frequent renewal, could mitigate risks emanating from price volatility; however, such an approach could induce substantial transaction costs and compromise the stability afforded by long-term business relationships.


1. Long-term Contracts and Relationship-specific Investment

Relationship-specific investments pertain to expenditures that yield minimal returns when repurposed beyond the originally intended contractual obligations. An illustrative example is a custom-made component designed for a specific product, which may be of negligible use for other products. Given the irreversibility of these investments—deemed as "sunk" once incurred—the termination of planned trade would result in substantial losses for the investor. Post-investment, the counterparty could potentially adopt opportunistic behaviour to optimize returns, a possibility that could engender mutual reluctance to engage in beneficial trade and investment—a predicament referred to as the 'hold-up problem'. Conversely, long-term contracts can shield the investor and mitigate the hold-up problem, particularly when relationship-specific investment is paramount, thereby fostering a more cooperative and long-term investment strategy between contracting parties. 

One notable shortcoming of long-term contracts is the limited flexibility to adapt to evolving market conditions. The longer the contractual duration, the greater the likelihood of encountering unforeseen risks associated with fluctuations in raw material prices. To shield against the impacts of abrupt shifts in production costs, contracting parties often incorporate specific provisions in the contract, the PAC being a prime example.

Joskow (1988), emphasizing the importance of relationship-specific investment, evaluated the suitability of the PAC within the context of long-term contracts. His analysis focused on the coal industry, characterized by longer-term contracts and substantial relationship-specific investments on the part of the seller, yielding high economic value. Joskow posited that a flexible-price contract featuring a PAC presented more advantages than a fixed-price counterpart, especially given the high market uncertainty in the industry over the contractual duration. Out of 250 contracts studied, approximately 63% (158 contracts) contained a PAC.

The demand-supply dynamics in the coal industry differ from those found in subcontract or consignment contracts; however, they provide insight into the potential merits of a PAC. The PAC facilitates the preservation of long-term relationships and fosters positive attitudes toward relationship-specific investments, even amidst uncertain future raw material prices. For instance, decreasing market prices could incentivize buyers to terminate existing contracts or transition to short-term alternatives offering cost savings. However, a delivery price adjustable in response to market conditions obviates the need for buyers to source new suppliers, thereby sustaining long-term contracts and preserving relationship-specific investments. Conversely, rising market prices could result in losses for providers under fixed-price contracts, yet the subcontractor might be held up in the relationship to protect their relationship-specific investment. The contract may persist for the remaining term, but the relationship-specific investment might diminish in the beginning. 

The demand-supply dynamics in the coal industry differ from those found in subcontract or consignment contracts; however, they provide insight into the potential merits of a PAC. The PAC facilitates the preservation of long-term relationships and fosters positive attitudes toward relationship-specific investments, even amidst uncertain future raw material prices. For instance, decreasing market prices could incentivize buyers to terminate existing contracts or transition to short-term alternatives offering cost savings. However, a delivery price adjustable in response to market conditions obviates the need for buyers to source new suppliers, thereby sustaining long-term contracts and preserving relationship-specific investments. Conversely, rising market prices could result in losses for providers under fixed-price contracts, yet the subcontractor might be held up in the relationship to protect their relationship-specific investment. The contract may persist for the remaining term, but the relationship-specific investment might diminish from inception. 

In this context, the greater the uncertainty in raw material prices and the significance of the relationship-specific investment—i.e., when the investment can yield substantial economic gains for the trading parties?the higher the likelihood of deriving benefits from preserving stable, long-term contracts featuring PACs, thus protecting the investors. Indeed, industries characterized by high volatility and sensitivity to relationship-specific investment, such as natural gas and petroleum coke, predominantly engage in contracts extending beyond ten years, most of which incorporate PACs.

2. Risk Sharing and Risk Premium

As previously elucidated, the PAC within a bilateral agreement has been scrutinized as a contractual construct that incentivizes the preservation of long-term relationships and ensures the protection of relationship-specific investments. However, given that the PAC is predicated on risk sharing in uncertain market environments, it is crucial to consider the risk allocation and the resultant rewards.

Specifically, a subcontract or consignment agreement constitutes a bilateral negotiation; however, adopting a model wherein the prime contractor is considered the project owner (or order placer) and the subcontractor is the successful or participating bidder, this study seeks to derive meaningful inferences through analyzing the impact of the PAC on bidding behaviours. To the best of the author's knowledge, mandatory PACs are present solely within public sector procurements and tenders, not in contracts between private entities. Hence, employing public procurement data, this study endeavours to estimate the effect of the PAC. 

In the context of public procurement, a mandated PAC might appear beneficial for the successful bidder but disadvantageous for the government (prime contractor), as it transfers the risk associated with rising raw material prices to the government. However, this conclusion might not necessarily hold true from the perspectives of economics and empirical analysis, given the trade-off effect between risk and price. In essence, a contract that transfers risk to the government is sufficiently attractive to potential operators (subcontractors) to potentially intensify bidding competition, resulting in a decrease in the winning bid. 

Theoretically, when firms (sellers) exhibit risk aversion, the government can reduce procurement costs through contracts that allocate a greater proportion of risk to the government (Holt, 1979). Additionally, a lower uncertainty in contract delivery prices can trigger aggressive bidding competition even among risk-neutral firms (Hong and Shum, 2002; Goeree and Offerman, 2003). To date, only a limited number of studies have empirically examined the effect post-PAC adoption. Some key findings from these analyses, summarized in using US Department of Transportation's procurement data, generally view the PAC favourably. With the exception of a single inconclusive study, most suggested that the adoption of the PAC resulted in a decrease in the successful tender ratio amidst intensifying bidding competition. In other words, in exchange for risk sharing, the government procures contracted items at a reduced cost.

Drawing from these findings, the impact of raw material price uncertainty on the main contractor and subcontractors under two distinct contract types—fixed-price and flexible-price (PAC)—can be gauged. Firstly, when the risks tied to raw material price volatility are minor, a fixed-price contract might offer more efficiency and stability. However, when uncertainty is high, parties may consider incorporating a PAC into the contract as a method for sharing risk. The nuances of contract provisions may hinge on anticipated price fluctuations of raw materials and the contracting parties' aversion to risk.

Consider a fixed-price contract. If there's a risk of further price increases, subcontractors may likely append a risk premium to the initial delivery price during contract negotiations, preparing themselves for increased production costs stemming from the price surge. Conversely, a risk premium becomes unnecessary under a flexible-price contract, implying that the delivery price can be set lower. For a prime contractor unable to pass on all additional costs (due to escalating delivery prices) onto consumers, some losses might occur, but it could benefit from cost reductions if the initial per-unit contract delivery price is set low.

When the risk of falling prices is high, a distribution issue could emerge on how to split the economically enlarged 'pie' due to cost reductions. Compared to a price hike scenario, the contracting parties might be less sensitive to gains and losses dictated by the presence or absence of a PAC in their contract. Under a fixed-price contract, the subcontractor reaps the benefit of cost reduction, but under a flexible-price contract (with a PAC), the subcontractor’s profitability stays stable, while the prime contractor can enhance its cost competitiveness. However, under a fixed-price contract, the prime contractor may see its competitiveness diminish due to a comparative disadvantage. The extent of potential damage to the prime contractors would depend on the competitive dynamics within the final goods market.

In short, particularly when there's a high risk of price escalation, if the prime contractor assumes the risk through the PAC, there's no need for the subcontractor to include a risk premium, leading to a natural decrease in the initial contract price. For a prime contractor capable of managing risk, paying less while assuming risk may be appealing, and a risk-averse subcontractor might willingly accept a lower delivery price in exchange for less uncertainty. This tendency is corroborated in a study of the asphalt industry (Skolnik, 2011, p.5). According to an article in Asphaltopics, during the period of sharp price increases in asphalt and cement from late 2005 to mid-2006, subcontractors without a PAC in their agreements demanded reflection of prospective price hikes and raised the delivery prices. Consequently, the prime contractor bore the burden of increased costs, even in the absence of an actual price surge. Conversely, contracts featuring a PAC effectively eliminated this 'de facto' risk premium. While delivery prices owed by the prime contractor could vary in line with asphalt price fluctuations, actual costs saw reductions as there was no risk premium appended.


3. Capability to Mitigate the Impact of Raw Material Price Fluctuations and Incentives to Encourage Cost-Reduction Efforts 

Conversely, an escalation in raw material prices doesn't always equate to a rise in production costs. If costs can be mitigated through alternative avenues such as using different raw materials, modifying the proportion of raw material usage, managing inventories efficiently, and enhancing skills, adjustments to delivery prices may not be necessary. Under a cost-plus pricing scheme where the delivery price mirrors supply and production costs, subcontractors (suppliers) lack incentives to strive for cost reduction, as posited by Joskow (1988). 

In real-world public procurement projects, the ability to absorb shocks caused by price swings is one of the essential competencies a subcontractor (successful bidder) must possess. Guidelines from the Asian Development Bank (ADB) suggest that price adjustments might be influenced by the type of construction method selected (ADB, 2018, Box 4). Skolnik's 2011 research on price adjustments in procurement contracts conducted by the US Department of Transportation (DOT) offices (p.92, p.101), indicates that the utility of a PAC varies based on the subcontractor's ability to manage production costs. If a rise in raw material prices is beyond a supplier's control, the prime contractor is incentivized to dissuade the subcontractor from assuming excessive risk. The reason being, if a subcontractor becomes unable or unwilling to fulfill the contract due to price concerns, the prime contractor's project may end up in jeopardy. 

In summary, when raw material price volatility is high and sudden price swings are challenging to manage, a PAC can aid contracting parties in safeguarding their relationship-specific investments and attaining mutual benefits. The clause can serve as a sound, justifiable option, particularly in the current scenario of soaring raw material prices. Globally, there's an increasing demand for legal consultation on how to integrate a PAC into a contract, particularly within the construction industry.



III. Potential Challenges to the Adoption of Mandatory PAC

The PAC is not an optimal choice in all situations. If price volatility is minimal or the impact of price swings on production cost is manageable, a fixed-price contract may be beneficial to both parties as it reduces trade costs driven by contract complexity and performance. As illustrated in , the PAC can bring both benefits and costs to the involved parties. However, the terms and conditions of the clause should be established through appropriate discussions, taking into account the current circumstances. In other words, while the PAC has various advantages, mandating it raises distinct issues.

Firstly, imposing a mandatory PAC could distort market participants' choices and lead to inefficiencies, despite some instances where a fixed-price contract is more efficient. In the short term, attempts might be made to avoid the PAC burden by shortening the contract period or preserving the profit margin by distorting other contract terms. In the long term, some companies may alter their business structure. Economically, market participants are expected to make decisions about make-or-buy based on the trade cost, but when the burden of PAC is excessive, the prime contractor may opt for vertical integration, doing all the work internally, including tasks previously assigned to subcontractors. Consequently, subcontractors may face reduced job opportunities. 

It's true that economic efficiency cannot be the sole rationale to account for the hierarchical relationship between the prime contractor and subcontractor, as rules against the abuse of superior bargaining position serve the purpose of meeting social demand for fairness and protecting socially disadvantaged groups. However, even if the ultimate goal is to achieve a win-win result at some economic efficiency's expense, the government should be wary of potential unintended consequences, such as nullifying the policy. If the PAC is mandated in the presence of a bargaining power imbalance, the prime contractor may attempt to demand a cut in the delivery price in return for sharing the risks. This will not enhance the profitability of SMEs (subcontractors) and may exclude vulnerable companies from the market. In simple terms, the effectiveness of the policy designed to protect SMEs will wane, and unwanted outcomes may occur instead. With this in mind, when adopting a price adjustment system, a monitoring process should be implemented to check not only the initial contract delivery price but also any distortion in non-price contract terms, such as contract period. Implementing such monitoring and regulatory actions could entail substantial administrative costs.

Some may posit that it would not be challenging for the private sector to adopt the PAC, given that the clause is already in use in the public sector. While it's true that many governments worldwide, including Korea, commonly apply the clause in their procurement contracts, the fact that the prime contractor in public procurements is the government means that, from an economic perspective, the situation may not be the same for the private sector. 

In long-term public procurement contracts, the PAC can reduce uncertainty surrounding price increases in raw materials and protect the contracting parties from these price risks. However, it offers more than that. Originally, the clause was designed to achieve both social goals, such as protecting firms in a disadvantaged position, and to maintain the economic feasibility of the contract. As previously mentioned, the government, as a main contractor, might seek a reduction in delivery prices through the PAC, in exchange for promising to absorb some of the burden from subcontractors in the event of price hikes. This could lead to more bidders participating in the process. The clause can prevent subcontractors from being overly sensitive to price increases and demanding excessive risk premiums. In other words, there may be gains in economic efficiency when the PAC allows a relatively risk-neutral government to absorb the risk of price increases from risk-averse businesses.

In public procurement projects, reducing the initial contract price through the PAC can provide justification for ensuring the project's economic feasibility. However, since one of the underlying goals of the PAC in subcontracting agreements is also the protection of the subcontractor's profitability, a reduction in the initial contract delivery price cannot always be viewed positively. Especially if the gap in bargaining power between the primary contractor and subcontractor is large, there may be demands for excessive cuts in delivery price or attempts to distort certain subtle terms and conditions. Moreover, if the prime contractor is small-sized, it's likely to be highly risk-averse, potentially leading to another issue: if the prime contractor is the one to bear the risk from price swings and the contract price is not sufficiently reduced for the prime contractor to manage this risk, the prime contractor's earnings stability or profitability could be significantly impacted.

Looking into competition in the downstream market (final goods market) of the prime contractor can help better understand these types of situations. In public procurements, the government, as the main contractor and final consumer, absorbs all the risks of raw material price increases. But in transactions between private firms, the main contractor is not the end user. This means that if the delivery price rises in line with increased raw material prices, the prime contractor may be able to pass on its cost burden to consumers, depending on the competition situation in the final goods market. In other words, under a mandatory PAC, the main contractor and consumers in the market end up sharing the risk. The higher the cost pass-through rate, the more incentive the main contractor has to accept the clause, but consumers will bear the associated damage. This implies that the profitability of subcontractors can be maintained at the expense of consumer welfare.

Lastly, the cost of designing and enforcing the PAC must be considered. Essentially, to incorporate the clause into a contract, it is crucial to develop a valid and reliable price index to serve as a standard measure for adjusting the prices. Such an index is hard to find and impossible to apply unilaterally, since the cost can vary depending on contract elements like the type of subject matter and duration. Additionally, incorporating the clause itself is highly complex, and the administrative costs associated with enforcing the clause can be substantial. Therefore, it may not be feasible for the prime contractor alone to bear all these execution costs, as they represent a substantial burden, even for the government, which possesses better objectivity and tolerance for cost overruns. 


IV. Policy Suggestions

Prices serve as an essential mechanism in steering the functions of a market economy, optimally allocating resources and establishing an equilibrium between supply and demand. Imposing mandatory regulations, such as the Price Adjustment Clause (PAC), indicates a government's intervention in this critical price determination process. This form of regulation can induce profound and direct ramifications on the market structure, thereby necessitating scrupulous management of policy measures. While government interventions are justifiable responses to market failures, they require simultaneous, comprehensive analytical investigation to ascertain the actual occurrence of such failures, identify market-friendly alternatives, determine potential areas of market distortion due to intervention, and understand the severity and nature of adverse outcomes resulting from this distortion. Embracing methodologies such as evidence-based policy design can prove instrumental in mitigating the risks of policy failures and unanticipated repercussions.

The imposition of a mandatory PAC might catalyze a spectrum of undesired impacts encompassing economic efficiency, policy effectiveness, and potential side effects. Therefore, a meticulous exploration of extant formal data and statistical resources to facilitate further analysis and study proves crucial. The outcomes of the recent pilot project, despite its voluntary nature, could offer valuable insights. However, due to the voluntary participation, these results may not provide an accurate estimation of the impact of a mandatory PAC. In light of this, a comprehensive analysis of the current status and impact of the PAC within public procurement—where the clause has had long-term application—provides a reference point to inform future policy directions.

Consider a scenario in which the PAC is mandated solely for middle market enterprises or larger firms to regulate situations with significant disparities in bargaining power. In this case, primary subcontractors (SMEs) stand to benefit from the clause, whereas secondary and tertiary suppliers—arguably in more vulnerable positions than the primary contractor—might not receive equivalent protection. Similar dynamics may occur in public procurements. Empirical investigation into the effects of the PAC and identification of affected parties in public procurement would enable policy makers to devise more efficacious measures. 

Importantly, the PAC is not a zero-sum game where one party's gain necessitates another's loss. Mutual benefits are feasible, yet mandatory imposition could lead to isolated instances of singular parties bearing losses. Policies failing to assure substantial economic gains lack sustainability, necessitating the provision of incentives to encourage mutually beneficial cooperation. Thus, policy endeavors should concentrate on addressing bargaining power discrepancies and penalizing abusive practices rather than imposing a specific contract type. Provision of a standard contract template containing a socially appropriate clause on price adjustment, mirroring current government initiatives, would also prove beneficial. Moreover, the development of financial markets for insurance and futures to hedge against raw material price volatility, and fostering their effective utilization, represents a market-friendly strategy in the mid- to long-term perspective.