The design of the rules of a market can be an extremely important determinant of market outcomes. In the private sector and in academia this will often be called ‘contract design’, and in government this often takes the form of regulation.
Contract design and regulation can be complex because many characteristics and actions of parties to a transaction are not readily observable. Often, time and expense will be involved in monitoring inputs, outputs and outcomes of the delivery of a good or service, and it can be difficult to specify and monitor all of the things that are important to Government. Delivering and monitoring inputs, outputs and outcomes also involve different elements of risk, which has costs for both parties to a transaction.
Economic theory provides insights to the incentive structures that can help to ensure that the desired outcomes are delivered at a fair price. This includes consideration of how risk is distributed between buyers and sellers, and who is best placed to bear that risk.