The Simple Franchise Bidding Scheme

Demsetz contends that even though efficiency considerations may dictate that there be only one supplier in a natural monopoly industry, the unregulated market price need display no elements of monopoly. Conventional analysis is flawed by a failure to distinguish between the number of ex ante bidders and the condition of ex post supply. Even though scale economies may dictate that there be a single ex post supplier, large numbers competition may nevertheless be feasible at the initial bidding stage. Where large numbers of qualified parties enter noncollusive bids to become the supplier of the decreasing cost activity, the resulting price need not reflect monopoly power. The defect with conventional analysis is that it ignores this initial franchise bidding stage.

Franchise bids that involve lump-sum payments should be distinguished from those where the franchise is awarded to the bidder who offers to supply at the lowest per unit price. Awarding an exclusive franchise to the noncollusive bidder who will pay the largest lump-sum fee to secure the business effectively capitalizes the monopoly profits that thereafter accrue. But the product or service for which such a franchise is granted will be priced on monopolistic terms. To avoid that outcome, the franchise award criterion of lowest per unit price is favored/ Stigler, among others, evidently finds the argument persuasive (1968, pp. 18-19; 1974, p. 360).

Demsetz illustrates the argument by examining a hypothetical example in which the state requires automobile owners to purchase automobile license plates annually, where the plates in question are produced under decreasing cost conditions. To simplify the argument he strips away “irrelevant complications, such as durability of distribution systems, uncertainty, and irra- tional behavior, all of which may or may not justify the üsë of regulatory commissions but none of which is relevant to the theory of natural monopoly; for this theory depends on one belief only—price and output will be at monopoly levels if, due to scale economies, only one firm succeeds in producing the product” (1968, p. 57; emphasis added).2 Provided that there are many qualified and noncollusive bidders for the annual contract and that the contract is awarded to the party that offers to supply at the lowest per-unit price, “the winning price will differ insignificantly from the per-unit cost of producing license plates” (Demsetz, 1968, p. 61).

Demsetz and others evidently believe, moreover, that the argument is not vitiated when the simple case is extended to include such complications as equipment durability and uncertainty. Equipment durability need not lead to wasteful duplication of facilities since, should a potential supplier offer superior terms, trunk line distributional facilities can be transferred from the original supplier to the successor firm (Demsetz, 1968, p. 62). Whether regulation is warranted as a means by which to cope more effectively with uncertainty is met with the observation that “[l]ong-term contracts for the supply of [nonutility services] are concluded satisfactorily in the market place without the aid of regulation” (p. 64).

The dominant theme that emerges, occasional disclaimers to the contrary notwithstanding,3 is that franchise bidding for natural monopolies has attractive properties. It is a market solution that avoids many of the disabilities of regulation. Demsetz’s concluding remarks, in which he registers his “belief that rivalry of the open market place disciplines more effectively than do the regulatory processes of the commission” (1968, p. 65), are plainly in this spirit.

1. The Marginal Cost Pricing Objection 

Lester Telser takes issue with Demsetz’s treatment of natural monopoly on the grounds that franchise bidding gives no assurance that output will be priced efficiently on marginal cost terms:

[Demsetz] leaves readers with the impression that he is content with a situation in which the firm is prevented from obtaining a monopoly return and he does not raise the question of efficiency. Hence he implies that direct regulation of an industry subject to decreasing average cost is unnecessary if it is prevented from obtaining a monopoly return This misses the point. The controversy concerns regulation to secure efficiency and to promote public welfare. It does not concern the rate of return. [Telser, 1969, pp. 938-39]

Another way of putting it is that Demsetz does not identify the relevant social welfare function or evaluate his results in welfare terms. Failure to do so, coupled with the prospect that franchise bidding will not lead to efficient marginal cost pricing, is, in Telser’s view, a critical shortcoming of Demsetz’s approach.

Demsetz has responded to those criticisms by observing that marginal cost pricing was of secondary importance to his paper (1971, p. 356). Although a complete treatment of the natural monopoly problem would require that efficient pricing be addressed, his original article did not pretend to be complete (p. 356). He furthermore considers it doubtful that regulation leads to more efficient pricing than an appropriately elaborated bidding scheme (pp. 360-61).

I suggest, for the purposes of this chapter, that the marginal cost pricing issue be set aside and that the frictions associated with franchise bidding, which are glossed over in previous treatments, be examined instead. To the extent that filling the lacunae in Demsetz’s “vaguely described bidding process”—which Telser (1971, p. 364) mentions but does not investigate— involves the progressive elaboration of an administrative machinery, the advantages of franchise bidding over regulation are uncertain. If, despite such machinery, the price-to-cost tracking properties of regulation are arguably superior to those of franchise bidding, the purported advantages of franchise bidding are further suspect.

2. Irrelevant Complications 

The irrelevant complications to which Demsetz, refers—equipment durability and uncertainty—and dismisses in the context of his automobile license plate example are really the core issues. To be sure, steady state analysis of the type he employs sometimes, yields fruitful insights that have wide-reaching ap- plications. I submit, however, that the interesting problems of comparative institutional choice, are largely finessed when the issues are posed in steady state terms. Frank Knight’s admonitions to this effect, although expressed in a different institutional context (1965, pp. 267-68), have general application. The basic argument, which applies both to Knight’s interest in whether internal organization matters and to Demsetz’s concern with market modes of contracting, is this: Rates of convergence aside, any of a large variety of organizing modes will achieve equally efficient results if steady state conditions obtain. In circumstances, however, in which the opierating environment is characterized by a nontrivial degree of uncertainty, self-conscious attention to both the initial and adaptability attributes of alternative modes is warranted.

Demsetz’s treatment of franchise bidding emphasizes the initial supply price aspect and, as developed below, treats the matter of adaptability in a rather limited and sanguine way. As will be apparent, franchise bidding for public utility services under uncertainty encounters many of the same problems that the critics of regulation associate with regulation; as Goldberg (1976) argues, the problems inhere in the circumstances.

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

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