Another approach to the natural monopoly problem relies on the distinction between competition in the market and competition for the market. If potential suppliers of a service which was a natural monopoly were asked to bid in a competitive auction for the right to serve the market, there would exist an incentive for the winner to supply the service in a technically efficient manner, and the profit accruing to the selected supplier would be bid down to competitive levels. The winning bidder would set a price at the monopoly level, of course, and this would imply that output would be below competitive levels. But the government would receive the expected present value of the monopoly profits as part of the winning bid for the franchise. If the effects on consumers of output restriction are judged to be small relative to the potential gains in technical efficiency from introducing competitive bidding, and if the diversion of profits from a natural monopolist to the government permits tax reductions, it is conceivable that the simple auctioning of monopoly franchises could be chosen through the political process in preference to alternative methods of regulation.
A more sophisticated auction system which aims to correct for the monopolistic restriction of output is the Chadwick or Demsetz auction, named after the economists who developed the idea. Under this system bidders would tender prices at which they would be prepared to supply the market. We might then expect this price to be bid down to the level of average costs which would just give the winning contestant an incentive to remain in the business. The advantage of the system over one of price regulation is that the regulator is not required to have any knowledge of cost conditions. Instead, a competitive auction ‘reveals’ some information about costs as an outcome of the auction process. Although this system would appear to have some advantages, there are some notable difficulties associated with its implementation.
An auction system requires that a tender document is drawn up specifying exactly what it is expected the winning bidder should deliver. If quality is complex to define and difficult to monitor the adverse selection problem will be severe. Adverse selection may occur in any situation in which one party to a transaction (either the buyer or seller of a good or service) is in possession of information not known to the other. If buyers cannot tell whether goods are of high or low quality, for example, there will be a danger that poor quality goods will mainly be offered for sale. In the context of a Chadwick auction, bidders will have an incentive to shade their price lower in the hope of gaining the franchise while planning to reduce the quality of the product or service to a level which permits them to make a profit. This is called ‘ post-contractual opportunism’. The contractual problems of specifying and enforcing the obligations of the parties may be immense. Another related disadvantage is that the government or its agents must guess what type and quality of service is most appropriate rather than have this information generated by the market itself.
In the UK, the Independent Broadcasting Authority (IBA) awarded regional franchise contracts to television companies. Since revenue was derived from advertising, the price of the service to consumers did not arise and the franchises were awarded on the basis of ‘quality’. Some information about the expectations of the IBA with respect to ‘quality’ was given to bidders, but the criteria were inevitably subjective, and it is difficult to tell, after the award of a contract, what elements were of greatest importance in determining the outcome. Domberger and Middleton (1985) cite the words used by the IBA to ‘explain’ the award of the East of England franchise to Anglia TV. This company's strengths ‘seemed to the Authority, after full and careful discussion, to outweigh those which the application of the rival contender promised’.
Even more sophisticated auction systems have been proposed. One such system proposes that franchise applicants be permitted to solicit customers with offers of various types of service at specified prices. Potential subscribers would make their commitments, and the supplier with the largest sum total of promised receipts would win the auction. This suggestion does have the merit of involving final consumers in the assessment process, but it does not solve the adverse selection problem or remove the possibility of post-contractual opportunism.
The period of time over which the winning franchisee is permitted to supply the market is an important consideration. The shorter the period of the contract the less complex will be its provisions. As the duration lengthens, the franchisee will want protection against unforeseen changes in cost or demand conditions. Writing a document which isolates all possible future contingencies and the appropriate responses to them would be an impossible task, while vaguely phrased provisions would be likely to result in many disputes and possibly in litigation. On the other hand, short-term contracts imply frequent auctions and the possibility of continual changes in the franchisee. This will not only be disruptive and administratively costly but may create problems of asset valuation at the time of change-over.
Franchising of Cable Television
Williamson provides a case study of the award of a CATV (Community Antenna TV or cable) franchise in Oakland, California. The franchise duration was fifteen years and the invitation to bid specified the number and type of channels to be available, the technical characteristics of the system, the rate of progress in the construction of the system and penalty charges for failure to meet completion targets, the geographical area to be covered, and the connection charges for each subscriber. Subscribers were to pay a monthly fee, and the franchise was awarded to the company that was prepared to accept the smallest fee. The franchise was awarded to Focus Cable. Progress on the system was slower than forecast and the company appealed to the City to renegotiate the terms. As a result, technical specifications were amended, the construction schedule was lengthened, and penalty charges were reduced. Holding the company to the original terms would have resulted in bankruptcy, while terminating the agreement and inviting new bidders would have involved huge problems of asset valuation (see next section) and no assurance of a superior final outcome.
Source: Williamson (1985)
Where the capital requirements of the franchisee are not specific to the provision of the particular service involved, for example the equipment is easily transferable to alternative uses, then the outgoing franchisee can always opt to use the capital in another line of business or to sell it on the open market. Where, however, the capital concerned is specific and has a very low value in alternative uses, no franchisee will be prepared to invest unless somehow assured that, if the contract is terminated, it will be possible to retrieve the value of capital that remains. In short, the franchisee will fear ‘hold up’ by competitors at contract renewal dates. Clearly, reliance on negotiations between incoming and outgoing franchisees will not solve the problem since bargaining costs will be high, and no franchisee would consent to make the initial commitment of capital under such circumstances.
One alternative is for the principles of asset valuation to be clearly laid down in the initial agreement, although this would involve complex matters of accounting for economic depreciation on various classes of equipment. Another possibility is for the franchisor (the local or national government or its agents) to own the capital and lease it to the franchisee. This response to the problem of specific physical capital is called ‘ quasi-vertical integration’ when it occurs in other industrial contexts (i.e. the buyer of an input owns the necessary jigs and tools and leases them to the supplier). Even in this case there would be problems of ensuring the proper maintenance and use of the relevant assets.
Physical capital which is ‘sunk’ constitutes only one aspect of the problem of contract renewal. The incumbent franchisee would gain advantages over outsiders in any subsequent auction because of the ‘know-how’ that is accumulated over time. In any contractual relationship the passage of time and the resulting experience gained by the supplier implies that no potential replacement can have precisely the same qualities. The benefits of on-the-job learning can only be achieved if the contractual relationship between buyer and supplier is maintained. In the context of competitive bidding for a franchise it is possible to argue that the know-how embodied in the existing workforce can be used if a new management team employs substantially the same people. But it is not certain that employees will be indifferent to the existing managers or the aspiring ones. All sorts of implicit understandings may be under threat if a new management team takes over the running of an organization, and the workforce may be in a powerful position to thwart a successful rival bid at contract renewal.
In their study of television franchising in the UK Domberger and Middleton note that the duration of the contracts allowed incumbents to gain substantial advantages over outside competitors: ‘These advantages are essentially informational – the incumbent knows more about the objectives of the Independent Broadcasting Authority than a potential bidder does and will have acquired intimate knowledge of the regulatory authority's preferences and personalities.’
Source: Domberger and Middleton (1985)
The competitive bidding solution to natural monopoly is attractive, but its role depends crucially on the contractual problems discussed above. Where small amounts of relatively non-specific capital are involved, where technology and demand conditions are relatively stable, where the quantity and quality of service are relatively easy to define, measure and police, and where penalty clauses are clear and enforceable, the competitive auction would appear to be an important arm of policy. As sunk costs increase in importance, as uncertainty becomes more pronounced, as contractual terms become more complex and costly to enforce, other forms of regulation are more likely to be observed. Post-contractual negotiation means that ‘franchise bidding requires the progressive elaboration of an administration apparatus that differs mainly in name rather than in kind from that which is associated with the regulation that it is intended to supplant’ (Williamson 1985 p. 350). Just as price control came, under certain conditions, to resemble rate of return regulation (Section 3.5), so franchise bidding may tend in practice to gravitate towards the same system as a response to the transactional hazards encountered.
