It will be useful to examine franchise contracts of three types: once-for-all contracts, which appear to be the type of contract envisaged by Stigler; incomplete, long-term contracts, which are favored by Demsetz; and recurrent short-term contracts, which Posner endorses.
1. Once-For-All Contracts
Stigler’s views on franchise bidding are limited mainly to an endorsement of Demsetz’s prior treatment of those matters. He observes simply that “(njatural monopolies are often regulated by the state. We note that customers can auction off the right to sell electricity, using the state as the instrument to conduct the auction, and thus economize on transaction costs. The auction consists of a
promise to sell cheaply” (1968, p, 19). Since he gives no indication to the contrary, Stigler apparently intends that such bidding be regarded as a serious alternative to regulation under actual market circumstances—which is to say under conditions of market and technological uncer-tainty. Failure to refer to recurrent bidding also suggests that the bidding scheme proposed is of the once-for-all variety.
Once-for-all contracts of two types can be distinguished: complete con-tingent claims contracts and incomplete contracts. The former require that each prospective franchisee specify the terms (prices) at which he is prepared to supply service now and, if price changes are to be made in response to uncertain future events, the conditional terms under which he will supply service in the future. It is generally appreciated that complete contracts of this kind are impossibly complex to write, negotiate, and enforce (Radner, 1968). The underlying transactional disabilities have been discussed in earlier chapters.
Given the infeasibility of complete contingent claims contracts, incomplete once-for-all contracts might be considered. Contractual incompleteness, however, is not without cost. Although incomplete once-for-all contracts are feasible in the sense that bounded rationality constraints are satisfied, such contracts pose hazards by increasing the risk of opportunism. The problems here are substantially those discussed below in conjunction with incomplete long- term contracts.
2. Incomplete Long-Term Contracts
Demsetz evidently has in mind that franchise awards be of a long-term kind in which adaptations to unanticipated developments are accomplished by permit- ting renegotiation of terms subject to penalty clauses (1968, pp. 64-65). Such renegotiation would be unnecessary, of course, if the parties to the contract could agree, at the outset, to deal with unanticipated events and to resolve conflicts by employing a joint profit maximizing decision rule, thereafter to share the gains of the resulting adaptation. General agreements to that effect are not self-enforcing, liowever, unless the profit consequences are fully known to both of the parties and can be displayed, at low cost; to an impartial arbitrator. Absent this, each party will be inclined, when the unanticipated events occur, to manipulate the data in a way that favors its interests.
To be sure, aggressive self-interest seeking of a myopic kind is attenuated both by the existence of informal sanctions and by an appreciation between the parties that accommodation yields long-run benefits (Macaulay, 1963). But the hazards of opportunism scarcely vanish on those accounts. Among the problems to be anticipated when incomplete long-term contracts are negotiated under conditions of uncertainty- are the following: ( 1 ) the initial award criterion is apt to be artificial or obscure; (2) execution problems in price- cost, in other performance, and in political respects are apt to develop; and (3) bidding parity between the incumbent and prospective rivals at the contract renewal interval is unlikely to be realized. Consider these several conditions seriatim.
2.1. ARTIFICIAL OR OBSCURE INITIAL AWARD CRITERION
The promise to “supply cheaply” is scarcely a well-defined commitment unless the quality of service is well specified and scalar valued bids possess economic merit. Posner recognizes the former and proposes that subscriber preferences regarding quality be ascertained by a preaward solicitation. The mechanics involve
… an “open season” in which all franchise applicants were free to solicit the area’s residents for a set period of time. This would not be a poll; the applicants would seek to obtain actual commitments from potential subscribers. At the end of the solicitation period, the commitments received by the various applicants would be compared and the franchise awarded to the applicant whose guaranteed receipts, on the basis of subscriber commitments, were largest. In this fashion the vote of each subscriber would be weighted by his willingness to pay, and the winning applicant would be the one who, in free competition with the other applicants, was preferred by subscribers in the aggregate. To keep the solicitation process honest, each applicant would be required to contract in advance that, in the event he won, he would provide the level of service, and at the rate repre- sented. in his solicitation drive. [Posner, 1972, p. 115]
The comparability problems that would otherwise be posed if both price and quality were permitted to vary at the final competition stage are thus avoided. The preaward solicitation not only prevents the quality level from being set by a political body, but also relieves the need to choose among disparate price-quality mixes, on grounds that are uncertain, at the final competition.
However imaginative this preaward solicitation process of Posner, it is not obviously practicable. For one thing, it assumes that subscribers are able to assess quality-price packages abstractly and have the time and inclination to do so—which poses a bounded rationality issue.6 For another, it aggregates preferences in a rather arbitrary way. Finally, it assumes that subscribers w.ll demand that winners provide the level of service at the rate represented or can otherwise obtain satisfaction for failure to perform. This poks execution issues and is discussed under b below.
If, additionally, the prices at which service is supplied are t<j vary with periodic demands—a measure that often has efficient capacity rationing prop- erties for public utility services—a complex variable load pricing schedule, rather than a single lowest bid price, must be solicited. Vector valued bids clearly pose award difficulties.
The upshot is that, although franchise awards can be reduced to a lowest- hid price criterion, that is apt to be artificial if the future is uncertain and the service in question is at all complex.’ Such awards are apt to be arbitrary and/or pose the hazard that “adventurous” bids will be tendered by those who are best- suited or most inclined to assume political risks. Again, this gives ries to execution issues, to which we now turn.
2.2. EXECUTION PROBLEMS
Even if contract award issues of the kinds described above either were absent or could be dismissed as de minimis, we would still have to face problems of contract execution. It is at the execution stage and in conjunction with contract renewal that the convergence of franchise bidding to public utility regulation is especially evident.
I assume, for the purposes of this subsection, that there is a strong presumption that the winner of the bidding competition will be the supplier of the public utility service over the entire contract period. Only in the event of egregious and persistent malperformance would an effort be made to replace the winning franchisee.
The assumption is supported by the following considerations. First, the award of a long-term contract plainly contemplates that the winner will be the supplier over a considerable period. A leading reason to make the contract long term is to provide the supplier with requisite incentives to install long- lived assets.9 If any slight failure to perform in accordance with the franchisor’s expectations would occasion rescission of the franchise, the longterm contract would be a fiction and its investment purposes vitiated.
The prospect of litigation delays and expenses also discourages an effort to displace a franchisee. Moreover, even if such an effort were successful, nontrivial transition costs would be incurred. (They are discussed further under c below.) Finally, franchise award agencies, like other bureaucracies, are loath to concede or be accused of error. As Eckstein puts it, publicly accountable decision-makers “acquire political and psychological stakes in their own decisions and develop a justificatory rather than a critical attitude towards them” (1956, p. 223). Since displacement may be interpreted as a public admission of error, franchise award agencies predictably prefer, when faced with malperformance, to negotiate a “compromise” solution instead.
In circumstances in which long-term contracts are executed under condi- tions of uncertainty, fixed price bids are apt to be rather unsatisfactory. If the environment is characterized by uncertainty with respect to technology, demand, local factor supply conditions, inflation, and the like, price-cost divergences and/or indeterminacies will develop.
To be sure, some of these divergences can be reduced by introducing price flexibility by formula (Fuller and Braucher, 1964, pp. 77-78; Goldberg, 1976b, p. 439). Adjustment for changes in the price in response to some index of prices is one possibility. It is, however, a relatively crude correction and unlikely to be satisfactory where there is rapid technical change or where local conditions deviate significantly from the index population. More precise tracking of prices to costs will be realized if, instead of fixed price contracts, cost plus (or cost sharing) contracts are negotiated. All of the difficulties associated with the execution of defense contracts of the cost sharing kind then appear, however (Scherer, 1964; Williamson, 1967a). Problems of auditing and of defective incentives are especially severe. (Those, it will be noted, are disabilities associated with regulation. Franchise bidding is designed to overcome them.)
A lack of specificity in the contract with respect to the quality of service and a failure to stipulate monitoring and accounting procedures accords latitude to franchisees during contract execution. Despite ex ante assurances to the contrary, franchisees can rarely be made to fulfill the spirit of an agreement if net revenues are enhanced by adhering to the letter of the contract only (CTIC 1972a, p.11). Moreover, technical standards by themselves are not self- enforcing; enforcement requires that a policing apparatus be devised (CTIC 1973, p.7). Since individual consumers are unlikely to have the data or competence to evaluate the quality of service in a discriminating way (Goldberg, 1976) and since both setup cost and specialization of labor economies will be realized by assigning the quality evaluation function to a specialized agency, centralization is indicated. But again, the convergence toward regulation should be noted.120
It may not be sufficient, moreover, merely to specify a common quality standard for all bidders. Thus, suppose that one bidder proposes to achieve the specified quality target by installing high-performance, long-lived equipment, that a second proposes to have backup equipment ready in the event of breakdown, and that the third claims that he will invest heavily in maintenance personnel. Although only one of them may fully satisfy the requirements, both subscribers and the franchising agency may lack the ex ante capacity to discern which. Granting the franchise to the low bidder only to discover that he is unable to perform as described is plainly unsatisfactory. Although penalty clauses in contracts can help forestall such outcomes, it is often the case—as the history of defense contracting suggests—that successful bidders are able to have terms renegotiated to their advantage.
Accounting ambiguities coupled with the disinclination of franchising agencies to allow winning bidders to fail permit franchisees to use accounting data in a strategic way—to include the threat of bankruptcy—during re- negotiations. The introduction of monitoring and accounting control techniques can prevent such outcomes, but that measure then joins the winning bidder and the franchising agency in a quasi-regulatory relationship.
In circumstances where renegotiation is common and perhaps vital to the profitable operation of a franchise, political skills assume special importance. Prospective suppliers who possess superior skills in least cost supply respects but who are relatively inept in dealing with the franchising bureaucracy and in influencing the political process are unlikely to submit winning bids.121 To the extent that political skills override objective economic skills, the advantages of franchising over regulation are placed in question.
Indeed, if franchisees are subject to less stringent profit controls than regulated firms (where the latter are subject to rate of return constraints), it may well be that franchising encourages greater political participation. The argument here is that the incentive to invest private resources to influence political decisions varies directly with the degree to which the resulting advantages can be privately appropriated—and that franchised firms have an appropriability advantage in this respect.12
2.3. BIDDING PARITY AT CONTRACT RENEWAL
Bidding parity at contract renewal intervals will be upset if winners realize substantial advantages over nonwinners. Award advantages of three kinds can be distinguished: economic, administrative, and political. The economic advantages have their origins in the fundamental transformation—a contracting phenomenon that was first introduced in Chapter 2 and has made its appearance in a variety of contracting contexts since. The administrative advantages arise in conjunction with asset valuation and related problems that would attend a franchise transfer. Issues of both kinds are discussed in subsection 3.3 below.
CAT.V is still a young industry, and many communities have yet to solicit renewal bids. Predictably, interest in securing immunity from rivalry at the franchise renewal date has been building among incumbent franchisees. Original agreements to submit to the discipline of competition and the hypothetical benefits of competition are mere contrivances; the reality is that competition is a hair shirt. Incumbency advantages notwithstanding, why submit to the threat of nonrenewal and to the scrutiny that such a renewal bidding competition would entail? Skeletons will unavoidably be exposed. Considering the administrative difficulties and legal challenges that would attend a nonrenewal, why go through the exercise? Such concerns have struck a responsive political chord. The U.S. Senate has passed a bill that would give “substantial preference to the initial franchisee” in return for leased access to channel capacity for up to 15 percent of the system (Price, 1983, p. 32). Whether this or some variant eventually becomes public law, the prospect that politicians will permit unrestrained competition on the merits at franchise renewal time is surely doubtful (Cohen, 1983). Only political innocents would claim otherwise. The Oakland, California franchise experience reported in the appendix is corroborative.
3. Recurrent Short-Term Contracts
A leading advantage of recurrent short-term contracting over long-term con- tracting is that short-term contracts facilitate adaptive, sequential decisionmaking. The requirements that contingencies be comprehensively described and appropriate adaptations to each worked out in advance are thereby avoided Rather the future is permitted to unfold and adaptations are introduced, at contract renewal intervals, only to those events which actually materialize. Put differently, bridges are crossed one (or a few) at a time, as specific events occur. As compared with the contingent claims contracting requirement that the complete decision tree be generated, so that all possible bridges are crossed in advance, the adaptive, sequential decision-making procedure economizes greatly on bounded rationality.
Additionally, under the assumption that competition at the contract renewal interval is efficacious, the hazards of contractual incompleteness that beset incomplete long-term contracts are avoided. Failure to define contractual terms appropriately gives rise, at most, to malperformance during the duration of the current short-term contract. Indeed, recognizing that a bidding competition will be held in the near future, winning bidders may be more inclined to cooperate with the franchising authority, if specific contractual deficiencies are noted, rather than use such occasions to realize temporary bargaining advantages.13 Opportunism is thereby curbed as well.
The efficacy of recurrent short-term contracting depends crucially, how- ever, on the assumption that parity among bidders at the contract renewal interval is realized.’5 Posner faces and disposes of this issue:
|T|he fact that the cable company’s plant normally will outlast the period of its franchise raises a question: Will not the cable company be able to outbid any new applicant, who would have to build a plant from scratch? And will not the bargaining method therefore be ineffective after the first round? Not necessarily: in bidding for the franchise on the basis of new equipment costs, new applicants need not be at a significant disadvantage in relation to the incumbent franchisee. For example, once a new applicant is franchised he could negotiate to purchase the system of the existing franchisee, who is faced with the loss of the unamortized portion of his investment if his successor builds a new system. Insofar as the economic life of a cable plant is considered a problem when the franchise term is short, it can be solved by including in the franchise a provision requiring the franchisee, at the successor’s option, to sell his plant (including improve- ments) to the latter at its;original cost, as depreciated. [Posner. 1972. p. 116|
I find these views overly sanguine. For one thing, equipment valuation problems are apt to be rather more complex than Posner’s remarks suggest. Secondly, Posner focuses entirely on nonhuman capital: the possibility that human capital problems also exist is nowhere acknowledged. To be sure, human asset benefits that accrue during contract execution and that give incumbents an advantage over outsiders will, if anticipated, be reflected in the original bidding competition. But “buying in” can be risky, and the price tracking properties of such strategies are easily inferior to average cost pricing in resource allocation respects. The upshot is that recurrent bidding (at, say, four-year intervals) is riddled with contractual indeterminacies.
Concern over plant and equipment valuation is, of course, mitigated if the investments in question are relatively unspeciali/.ed. I conjecture that this is the case for Demsetz’s automobile license plate example. If, with only minor modifications, general purpose equipment (for the cutting, stamping, painting, and so on) can produce license plates efficiently, then a franchisee who fails to win the renewal contract can productively employ most of this same equipment for other purposes, while the new winner can, at slight cost, modify his own plant and equipment to produce the annual requirement efficiently.
Alternatively, concern over plant and equipment poses no problem if its useful life is exhausted during the contract execution interval. As Posner’s remarks suggest, however, and as is generally conceded, it is inefficient to install utility plant and equipment of such short duration.
Unlike Demsetz’s license plate manufacturers, moreover, most utility services (gas. water, electricity, telephone) require that specialized plant and equipment be put in place. The same is true of CATV. Since the construction of parallel systems is wasteful and since to require it to be done would place outside bidders at a disadvantage at the contract renewal interval, some method of transferring assets from existing franchisees to successor firms plainly needs to be worked out.
Posner contends that it can be handled by stipulating that plant and equipment be sold to the successor firm, at its option, at the original cost less depreciation of the predecessor franchisee. Consistent with his emphasis on fundamental policy choices, Posner declines to supply the details. Unfortunately, however, the details are troublesome.
For one thing, original cost can be manipulated by the predecessor firm. For another, even if depreciation accounting procedures are specified under the original franchise terms, implementation may still be contested. Third, original cost less depreciation at best sets an upper bound—and perhaps not even that, since inflation issues are not faced—on the valuation of plant and equipment. The successor franchisee may well offer less, in which case costly haggling ensues. Finally, even if no disputes eventuate, Posner’s procedures merely provide a legal rule for transferring assets. He does not address the economic properties of the procedures in investment incentive and utilization respects.
Whether the accounting records of original costs can be accepted as recorded depends in part on whether the equipment was bought on competitive terms. The original franchisee who is integrated backward into equipment supply or who arranges a kickback from an equipment supplier can plainly rig the prices to the disadvantage of rival bidders at the contract renewal interval. Furthermore, and related, the original cost should also include the labor expense of installing plant and equipment. To the extent, however, that the allocation of labor expense between operating and capital categories is not unambiguous, the original winner can capitalize certain labor expenses to the disadvantage of would-be successors. Auditing can be employe^ to limit those distortions, but that has the appearance of regulation. Even if carefully done, moreover, the results are apt to be disputed. Inasmuch as information on true valuation is asymmetrically distributed to the disadvantage of outside ‘parties, the burden of showing excess capitalization falls heavily on the would-be new supplier.
Reaching agreement on depreciation charges, which arc notoriously dif- ficult to define (especially if obsolescence is a problem and maintenance expenditures can be manipulated in a strategic manner), poses similar prob- lems. Therefore, costly arbitration, for both original equipment valuation and depreciation reasons, is apt to ensue.16 Rate base valuations of a regulatory kind thereby obtain.
Indeed, the valuation of physical assets is predictably more severe under franchise bidding than under regulation. For one thing, earnings in the regu-lated firm are a product of the rate base and the realized rate of return.
Clearly, the regulated firm can be conciliatory about the rate base if in exchange it receives allowable rate of return concessions. Additionally, the regulatory agency and regulated firm are prospectively joined in a long series of negotiations. Errors made by either party on one round are less critical if they can be remedied at the next rate review interval (or if, in a crisis, interim relief can be anticipated). More is at stake with asset valuation under franchise bidding, since degrees of freedom of both rate of return and intertemporal kinds are missing. Accordingly, more contentious bargaining leading to litigation is to be expected.
A related difficulty with Posner’s physical asset valuation scheme is that it merely sets an upper bound. Inasmuch, however, as procurement on those terms is left to the successor firm’s option, there is little reason to expect that figure to prevail. Without stipulating more, the successor firm would presumably offer to buy the specialized plant and equipment at its value in its best alternative (nonfranchised) use. That will normally be a small fraction of the depreciated original cost. Predecessor and successor firms thus find themselves confronted with a wide bargaining range within which to reach an exchange agreement. Since competitive forces sufficient to drive the parties to a unique agreement are lacking, additional haggling (which is a social cost) can be anticipated. Albeit vexing, the details, which are neglected by Posner, nevertheless matter; the frictionless transfer on which he appears to rely is simply not to be had on the terms described.
Conceivably superior asset valuation and franchise bidding schemes can be devised to mitigate those problems.17 It is patently incumbent, however, on those who believe that large numbers competition can be made effective at the contract renewal interval to come forward with the requisite operational details. Without such specificity, one must consider dubious the contention that low- cost resassignment of physical assets can be effected at the contract renewal interval for franchised services that require specialized and long-lived plant and equipment to be installed. Rather, nontrivial haggling and litigation expenses appear to infect Posner’s proposal.
Moreover, human asset problems, which Posner and Demsetz fail even to mention, also must be faced. Again, the matter of fungibility arises. To the extent that the skills of operating the franchise are widely available or, alter- natively, that employees of the incumbent firm deal with rival bidders and the incumbent’s owners on identical terms, no problems of this kind appear. If, however, nontrivial specialized skills and knowledge accrue to individuals and snfall groups as a result of on-the-job training and experience, the first of those conditions is violated. If, additionally, employees resist transfer of ownership in the bidding competition, rivals are put to a disadvantage.
The matter of nonredeployability of labor has been discussed in earlier chapters. As set out there, significant differences sometimes develop between experienced and inexperienced workers in the following respects: (1) Equip-ment idiosyncracies, due to highly specialized or incompletely standardized, albeit common, equipment, are “revealed” only to experienced workers; (2) processing economies of an idiosyncratic kind are fashioned or “adopted” by managers and workers in specific operating contexts; (3) informal team ac- commodations, attributable to mutual adaptation among parties engaged in recurrent contact, develop and are upset, to the possible detriment of group performance, when the membership is altered; and (4) communication idio- syncracies evolve (with respect, for example, to information channels and codes) but are of value only in an operating context where the parties are familiar with each other and share a common language.
As a consequence, it is often inefficient fully or extensively to displace the experienced labor and management group employed by the winner of the initial franchise award. Familiarizing another group with the idiosyncrasies of the operation and developing the requisite team production and communication skills are costly. Accordingly, incumbent employees, who alone possess idiosyncratic knowledge needed to realize least-cost supply, are powerfully situated to block a franchise reassignment effort.
The cost disadvantage referred to will obtain, however, only insofar as incumbent employees deal with the current ownership and outside bidders differently. The strategic advantage they enjoy in relation to inexperienced but otherwise qualified employees can be exercised against both the current owner and his bidding rivals alike. The issue thus comes down to whether current and prospective owners are treated differently at the contract renewal interval.18 I conjecture that they will be. The main reason is that informal understandings (with respect to job security, promotional expectations, and other aspects of internal due process) are much easier to reach and enforce in familiar circumstances than in unfamiliar ones.19
This is not to say that employees cannot or will not strike bargains with outsiders, but rather than such bargains will be more costly to reach because much more attention to explicit detail will be required, or there is greater risk associated with an informal (incompletely specified) agreement with outsiders Where additional detail is sought, outsiders will be at a disadvantage in relation to insiders, because the costs of reaching agreement are increased. If, instead, employees are asked to trust the outsider to behave “responsibly” or, alternatively, the outsider agrees to accept the interpretation placed on in- complete agreements by the employees when unanticipated events not expressly covered by the employment contract develop, the implied risks are great and corresponding premiums will find their way, directly or indirectly, into the bid price. As a consequence, idiosyncratic employment attributes coupled with the inability of outsiders to reach equivalent agreements at equal expense place original franchisees at an advantage at the contract renewal interval. Thus human capital considerations compound the bidding difficulties that physical asset valuation problems pose. To contend that bidding parity can be expected at the contract renewal interval is accordingly suspect for this reason as well. Put differently, if original winners of the bidding competition realize nontrivial advantages in informational and informal organizational respects during contract execution, bidding parity at the contract renewal interval can no longer be presumed. Rather, what was once a large numbers bidding situation, at the time the original franchise was awarded is converted into what is tantamount to a small numbers bargaining situation when the franchise comes up for renewal. A fundamental transformation thus obtains.
It might be argued, of course, that the incumbency advantage will be anticipated at the outset, in which event discounted certainty equivalent profits will be bid down to zero by large numbers competition for the original award. That is not, however, an entirely satisfactory answer. For one thing, to come in at a price below cost for the initial award (perhaps even a negative price) and to set price at the level of alternative cost at contract renewal intervals easily result in resource utilization of an inferior kind. Additionally, buying-in strategics are risky. The alternative supply price can-be influenced by the terms the franchisor sets on subsequent rounds, including terms that may obsolete the leaming-by-doing advantages of incumbents.
4. A Summing Up
Once-for-all bidding schemes of the contingent claims contracting kind are infeasible and/or pose execution hazards. Incomplete long-term contracts of the type envisaged by Demsetz alleviate the first of those problems but aggravate the second. A whole series of difficulties long familiar to students o defense contracting and regulation appears. The upshot is that franchise bidding for incomplete long-term contracts is a much more dubious undertaking than Demsetz’s discussion suggests.’
Posner’s proposal that franchise terms be kept short is designed to over- come the adaptability problems associated with incomplete long-term contracts, but his discussion is insufficiently microanalytic and/or critical of the disabilities of short-term contracts to expose their shortcomings. The fundamental limitation of the argument is that, despite Posner’s procedural stipulations (1972, p. 116), bidding parity at the contract renewal interval between the original winner and rival successor firms cannot safely be presumed. To the contrary, there are reasons to doubt such parity, in which case the adaptability and price to cost properties that Posner associates with recurrent contracting20 are not to be had on the frictionless (or low-cost) terms he describes.
To be sure, some of the difficulties that infect the Posner proposal can be mitigated by introducing an extensive regulatory/arbitration apparatus. Assessing plant and equipment installations, auditing related accounting records, and arbitrating disputes between incumbent and rival firms over physical asset valuations are illustrative. But then franchise bidding and regulation differ only in degree.
It is perhaps unsurprising, in view of the foregoing, that Posner’s recurrent bidding proposal has not been widely adopted. Rather, most CATV franchise awards are for ten to fifteen years, and contractual incompleteness has been handled by progressively elaborating a regulatory structure (CTIC, 1972c, pp. 9- 12)—a result that conceivably reflects a desire by CATV operators to insulate themselves from the rigors of competition. I submit, however, that the drift toward regulation is also explained by performance defects associated with CATV franchise awards which are caused in part by contractual incompleteness (CTIC, 1972c, p. 9).
Still the contractual incompleteness defects described above might con- ceivably be remedied by progressively refining CATV awards in the future. Stipulating appropriate penalities for unsatisfactory performance and setting out complex conditional responses to contingent events may serve to promote efficient adaptation and mitigate haggling expenses. Elaborating the contract in these respects is not costless, however, and franchising agencies often lack the resolve to exact penalties as prescribed.21 Many of the limits of franchise bidding described above were evident to students of regulation some eighty years ago:
Regulation does not end with the formulation and adoption of a satisfactory contract, in itself a considerable task. If this were all, a few wise and honest men might, once in a generation supervise the framing of a franchise in proper form, and nothing further would be necessary. It is a current fallacy and the common practice in American public life to assume that a constitution or a statute or a charter, once properly drawn up by intelligent citizens and adopted by an awakened public, is self- executing and that the duty of good citizens ends with the successful enactment of some such well matured plan. But repeated experience has demonstrated—what should have been always apparent—the absolute futility of such a course, and the disastrous consequences of reliance upon a written document for the purposes of living administration. As with a constitution, a statute, or a charter so with a franchise. It has been found that such an agreement is not self-enforcing. [Moreover, the] administration may ignore or fail to enforce compliance with those essential parts of a contract entrusted to its executive authority; and legal proceedings … are frequently unavoidable long before the time of the franchise has expired: [Fisher, 1907, pp. 39-40]
At the risk of oversimplification, regulation may be described contractually as a highly incomplete form of long-term contracting in which (1) the regulatee is assured an overall fair rate of return, in exchange for which (2) adaptations to changing circumstances are successively introduced without the costly haggling that attends such changes when parties to the contract enjoy greater autonomy. Whether net gains are thereby realized turns on the extent to which the disincentive effects of the former (which may be checked in some degree by performance audits and by mobilizing competition in the capital market forces) are more than offset by the gains from the latter. This is apt to vary with the degree to which the industry is subject to uncertainties of market and technological kinds.
Source: Williamson Oliver E. (1998), The Economic Institutions of Capitalism, Free Press; Illustrated edition.