Williamson (1976) - Franchise Bidding For Natural Monopolies

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© edegan.com, 2016

• This page is referenced in BPP Field Exam Papers

Reference(s)

• Williamson, Oliver E. (1976), "Franchise Bidding for Natural Monopolies-in General and with Respect to CATV", The Bell Journal of Economics, Vol. 7, No. 1 (Spring), pp. 73-104. pdf

Abstract

The orthodox attitude among economists toward regulation is one of "disdain and contempt". The general reputation is not undeserved, but it fails to discriminate among different economic activities and different types of regulation. An effort to distinguish between those circumstances in which regulation, in some form, is immanent from those in which market modes can be made to work relatively well is needed. Discriminating assessments of regaulated industries (extant and proposed) will be facilitated by examining transactions in much greater microanalytic detail than has been characteristic of prior studies of regulation and proposed alternatives thereto. My examination of franchise bidding for natural monopoly discloses that this mode suffers form much more severe contractual disabilities than have hirtherto been acknowledged. Faced with both technological and market uncertainties, CATV, circa 1970, does not appear to be among the circumstances for which unassisted franchise bidding can be expected to work well.

Vocabulary

De minimis - About minimal things; often used to discuss levels of risk that are too small to be concerned with Immanent - To remain within, used to suggest that an essence (or divine being) manifest in and through all aspects Lacunae - Missing sections of text Sanguine - Redish brown, or similar to a drawing done in these colours, or of blood, or optimistic (think a red faced happy person). Seriatim - In series or order Vitiated - To reduce the value or impare the quality of something

CATV - In this context: Community Antenna Television

A Franchise Scheme

Franchising in this context is the competitive bidding (of some form) for a long term contract to operate a monopoly.

Franchise bidding is examined as an alternative to regulation in the provision of public services for monopoly supply. Circa 1970 franchise assignment differed in degree from regulation, not in kind. The paper considers the implications of the 'microanalytic' detail, and its importance. Specially it examines the contracting. The former literature was based on anti-trust notions, whereas this paper takes a transaction cost approach (a more legal approach to economics). Choice among the relevant modes involves considering:

1. The costs of ascertaining and aggregation consumer preferences through solicitation
2. The efficacy of scalar bidding
3. The degree to which technology is well developed
4. The degree to which incumbent suppliers develop idiosyncratic skills
5. Demand uncertainty
6. The extent to which long-lived specialized equipment is involved
7. The susceptibility of the political process to opportunistic representations (and the differential proclivity to make them)

The more confidence one has in contracting (both at the outset and at renewals), the more one should favour the market modes. Regulation should be favoured more under incomplete contracting.

The prefered mode may change - perhaps monopoly is needed to start with, but not later. But there may be transactional problems in shifting modes.

Foundations

The following foundations are important:

• The economics of (e.g. Coasian) property rights
• Distinguish between ex ante and ex post
  • There may be ex ante competition between bidders but ex post a monopoly on supply
  • Ex ante efficiency appears possible with a large number of noncollusive bids
  • Ex post there will be a decreasing cost activity with a monopoly
• Distinguish between lump sum payments for contracts and lowest price per unit
  • Lump sum payments capitalize the monopoly rents - but the service will then be priced on monopoly terms
  • Lowest per unit cost may approximately equal marginal cost (with out TCE considerations)

Key people:

• Stigler: favoured lowest per unit competitive bidding
• Demsetz: stripped away "irrelevant complications" including:
  • Durability
  • Uncertainty
  • Irrational behaviour
• Posner: introduced a solicitation phase

Note that "irrelevant complicants" may lead to regulation:

• All modes are equivalent if steady state conditions emerge
• Uncertainty could be initial or regarding adaptability - the later would favour regulation (the former is not a problem)

Three Types of Contract

Once and For All Contracts

There are two types: Complete contingent claims and incomplete. It is generally accepted that the former is impossible. Thus incomplete contracts can lead to opportunism as discussed below.

Incomplete Long Term Contracts

Adaptation would be permitted through renegotiation with penalty clauses. Such contracts are not self-enforcing unless the profit consequences:

• are fully known to both parties
• can be displayed at low (or no) cost to an impartial arbitrator
• Otherwise manipulation of the data will results (strategic signalling)

Aggressive opportunism can be partially mitigated by informal sanctions, provided that there are mutual long run benefits. Particularly problematic are long run incomplete contracts where:

• The initial award criterior is apt to be artificial or obscure
• Execution problems are apt to develop in:
  • Price-cost
  • Other performance
  • Political respects
• Bidding partity between the incumbent and entrants at renewal will not be achieved.

To overcome problems with the initial award criteria, Posner recommended a solicitation phase that:

• Applicants would seek to obtain actual contracts from subscribers before bidding
• The bid would be the contract terms secured
• The winner would be the applicant with the largest gauranteed subscriber committments.

This has the following benefits:

• A political body does not need to determine the quality level
• Quality and price can vary at the competition stage

However it has the following cons:

• Subscribes must assess a service before recieving it (i.e. there are bounded rationality constraints)
• It aggregates preferences in an arbitrary way
• Leads to problems in execution - what if the provider can not meet the solicited offer?
• If demand varies so will price, so a pricing schedule must be provided
• Adventurous bids may be made by those most able to deal with political risk

Considering execution problems, it may be hard to displace a franchise, even one who fails to perform at the agreed level because:

• Long term contracts are to encourage investment in long-lived assets, this incentive is nulled if the contracts can be easily cancelled.
• Litigation delays and costs
• Award agencies may be loathed to admit a mistake

Considering price-cost relationships: under uncertainty fixed price bids are unsatisfactory. Flexibility can be built in through correlation to an index, or a move to cost-plus, but then the degree of monitoring required increases, which also gives rise to defective incentives.

Considering other performance attributes: quality of service etc, needs to be monitored. Individual consumers are unlikely to have the data, so set up costs and labour economies are obtained through specialization of this function - indicating centralization and regulation. Penalty clauses may help avoid extreme cases. Note that an agency may be unable to discern ex ante which of the three following possibilities is best:

1. High performance, long-lived equipment
2. Backup equipment
3. Investment in maintenance personnelle

Considering Politics: Political skills are important to assignees as they may assist in the construction of winning bids (if only because winners know how to navigate the bureaucracy). If franchising encourages greater profits, then there are greater rents to be captured, which gives incentives to invest in non-market strategies.

Considering lack of bidding parity: This is discussed later, but clearly incumbents may possess advantages that help them to win again.

Recurrent Short Term Contracts

Short term contract can help facilitate adaptive sequential decision making. If contract renewal is effacious (this precludes the need for long term investment) then opportunism can be avoid and this approach is best. But this requires parity among bidders. Parity may not be achievable because:

• Human capital will almost certainly accrue - this becomes a relational specific investment
  • Some part of it is almost certainly non-fungible
  • Employees may resist transfer to a new employer
  • The paper lists four differences between experienced and non-experienced workers (equipment idiosyncracies, processing economies, team accomodations, communication idiosyncracies) on page 88
• Unspecialized plant and equipment (long term) could be sold from the incumbent to the entrant but there may still be costly haggling as valuation can not be assured to be value minus amortization (which itself only gives an upper bound anyway). Note that this also would give perverse incentive to maintain equipment
  • Also, there may be ways to account for value differently (strategically), and set-up costs are problematic.
  • Unspecialized equipment that is fully used up (amortized) does not matter, nor does movable equipment
  • There may be ways to design mechanisms for dealing with this, but frictionless transfer is required (and unlikely)
• Equipment that represents a relational specific investment

Ed's Notes

This literature could be applied to the traditional franchising literature - rather than a social planner or government considering these contracts, a firm could be considering them. Franchising (in the business sense) is them a form of regulation (in the policy sense), and contracting (in the business sense) is a form of francising (in the policy sense).