Introduction to Franchise Bidding for Natural Monopoly

The case for a comparative institutional approach to regulation was succinctly put by Coase twenty years ago:

Contemplation of an optimal system may provide techniques of analysis that would otherwise have been missed and, in certain special cases, it may go far to providing a solution. But in general its influence has been pernicious. It has directed economists’ attention away from the main question, which is how alternative arrangements will actually work in practice. It has led economists to derive conclusions forcedriornic policy from a study of an abstract of a market situation. It is no accident that in the literature … we find a category “market failure” but no category “government failure.” Until we realize that we are choosing between social arrangements which are all more or less failures, we are not likely to make much headway. [Coase, 1964, p. 195; emphasis added]

Largely as a result of criticisms of this kind, much of it originating at Chicago, the study of regulation has been considerably reshaped. Thus whereas reference to market failures was once thought to be a sufficient condition for government intervention, there has been a growing realization that regulation is beset with problems of its own. Moreover, the limits of markets are now perceived to be less severe than was true of the interventionist era of the 1960s. The study of contracting in its entirety, in which both ex ante contracting and ex post implementation are considered, discloses that complex contracts can often be devised that are responsive to the needs of the parties.

The franchise bidding for natural monopoly literature acknowledges the limits Of regulation but deals with the issues of contracting in a very incomplete way. Specifically, it either does not examine how “alternative arrangements will actually work in practice” or does so in a highly sanguine way. As a consequence, the enthusiasts of franchise bidding claim too much for the efficacy of that organizational alternative. Applications that are supportable in one context (namely, where asset specificity is slight) are uncritically extended to circumstances where they are not (namely, where asset specificity is substantial).

That the franchise bidding for natural monopoly literature is flawed does not, however, mean that it has had an undesirable public policy impact. The deregulation of trucking and airlines arguably benefited from the viewpoint advanced in the franchise bidding literature. The investments in question here really are “assets on wheels,” hence lack specificity. But similar deregulation reasoning does not, without more, carry over to electric power generation or cable television systems. Given that the assets in question for electric power and cable are both long-lived and immobile, specific attention to the attributes of the enabling contracts is needed before a decision is reached to go forward with deregulation.

Thus although the limits of regulation are manifold, merely to show that regulation is flawed does not establish that regulation is an inferior mode of organizing economic activity. Not only do the disabilities of regulation vary with both the type of activity regulated and the form of regulation attempted, but there is an obligation to assess the properties of the proposed alternative— not only in general but also specifically with respect to the activity in question. If the proposed mode is flawed in similar or different respects, the purported advantages of shifting out of regulation may be illusory.

Among the factors that are relevant to an assessment of alternative modes of organizing natural monopoly services are the following: (1) the costs of ascertaining and aggregating consumer preferences through direct solicitation; (2) the efficacy of scalar bidding; (3) the degree to which technology is well developed; (4) demand uncertainty; (5) the degree to which incumbent suppliers acquire idiosyncratic skills; (6) the extent to which specialized, long- lived equipment is involved; and (7) the susceptibility of the political process to opportunistic representations and the differential proclivity, among modes, to make them. (Of special relevance in that last connection is the tendency for regulation, once put in place, to assert ancillary powers, thereby to expand its jurisdiction, often with dysfunctional Indeed, I conjecture that creeping “ancillariness” is one of the more severe disabilities to which regulation is subject.) The more confidence one has in contracting and in the efficacy of competition—both at the outset and at contract renewal intervals—the more one tends to favor market modes. Conformably, regulation, in some form, is relatively favored when one is dubious that incomplete contracting will yield desired results and when competitive processes are prone to break down.

Since variants within both market and regulatory modes exist, discrimi-nating assessments within as well as between modes are indicated. Also, a once- for-all verdict with respect to the supply of a particular natural monopoly service is unwarranted. The better mode at an early stage of an industry’s development may no longer be better later on when a lesser degree of uncertainty prevails. To the extent that difficult transition problems are apt to be posed in shifting from one mode to the other, this should be acknowledged and taken expressly into account at the outset.

Source: Williamson Oliver E. (1998), The Economic Institutions of Capitalism, Free Press; Illustrated edition.

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