ALTERNATIVE REGULATORY STRATEGIES AND THE ROLE OF PRIVATE CONTRACTS

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ALTERNATIVE REGULATORY STRATEGIES AND THE ROLE OF
PRIVATE CONTRACTS

• José A. Gómez-Ibáñez
• ACCC, July 2010
• OUTLINE
• SOURCES OF MONOPOLY POWER
• ANALOGY TO PROCUREMENT
• RANGE OF REGULATORY STRATEGIES
• ROLE OF PRIVATE CONTRACTS

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SOURCES OF MONOPOLY POWER

• Usual explanation Economies of scale
• Cost/customer
• Number of customers
• But also requires durable, immobile and costly
  investments by
• Infrastructure users, and
• Infrastructure suppliers

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• Classic example Municipal piped water
• Street with 2 small pipes
• Street with 1 large pipe

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• Durable, immobile, and costly investments
• Make investors vulnerable to opportunistic
  behavior by others
• Are common throughout economynot just
  infrastructure
• Usually solved by long-term private contracts

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TRANSACTION COSTS(Ronald Coase, Oliver
Williamson, Douglas North)

• TRANSACTION COSTS
• Costs of negotiating and enforcing agreements
• Arise because
• Not omniscient Hard to know every fact,
  anticipate every development
• Not saints Parties will behave opportunistically
  by withholding information
• Influence organization of economic activity

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ANALOGY TO PROCUREMENTMAKE OR BUY

• WHO MANAGES PRODUCTION?
• Independent suppliers
• Purchasing firm

• Buy on spot market
• Make internally (vertical integration)

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THE EXTREME OPTIONS

• BUY ON SPOT MARKET
• Pro Competition
• Reliability
• Con No relationship-specific
• investments
• MAKE INTERNALLY
• Pro Relationship-specific
• investments easy
• Con Must manage internally

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INTERMEDIATE OPTIONS

• WHO MANAGES PRODUCTION?
• Independent suppliers
• Purchasing firm

• Buy on spot market
• Classical contract
• Relational contract
• Make internally (vertical integration)

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INTERMEDIATE OPTIONS

• CLASSICAL CONTRACT
• Pro Contract limits opportunism
• Con Risk of incomplete
• contract
• RELATIONAL CONTRACT
• Pro Flexibility
• Con Requires extra-contractual
• limit on opportunism
• Corruption in procurement
• (principal-agent problem)

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PROCUREMENT OPTIONS

• If relationship specific investments important
• If hard to write complete contract
• If few extra-contractual limits on opportunism

• Spot market
• Classical contract
• Relational contract
• Make internally

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REGULATORY OPTIONS

• WHO DECIDES?
• (PRICE QUALITY)
• Markets
• Politics

• Spot markets
• Public enterprise

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REGULATORY OPTIONS

• WHO DECIDES?
• (PRICE QUALITY)
• Markets
• Politics

• Spot market
• Private long-term contracts
• Concession contract
• Discretionary regulation
• Public enterprise

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INTERMEDIATE OPTIONS

• PRIVATE CONTRACTS
• Customers contract directly with infrastructure
  supplier
• CONCESSION CONTRACTS
• Government contracts with infrastructure supplier
  on customers behalf
• DISCRETIONARY REGULATION
• Government regulators set price and service
  standards for infrastructure suppliers
• (Examples US cost-of-service regulation, UK
  price cap regulation)

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CONCESSION CONTRACTS

• PRO
• Contract prevents opportunism
• Fair if competitively tendered
• CON
• Risk of incomplete contract
• Consumers may not trust government to negotiate
  on their behalf

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DISCRETIONARY REGULATION

• PRO
• Flexibility to cope with unforeseen
• CON
• Technically difficult (information asymmetry)
• Risk of regulatory capture

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PRIVATE vs. CONCESSION CONTRACTS

• PRO
• Easier to write complete contract
• Easier to tailor services to customer
• Easier to renegotiate if incomplete
• CON
• Transactions costs may be high relative to value
  of contract
• Multiple sunk investments of different duration

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PRIVATE CONTRACTS LARGE CUSTOMERS

• U.S. Freight Railroads
• 19th Century Private contracts
• 1887 Interstate Commerce Act bans discrimination
• 1950s Railroad decline
• 1980 Railroad deregulation restores contracts
• Traffic up 67, tariffs down 51, profitability
  restored
• Contracts play major role 94 of captive
  traffic, 70 of all traffic
• Small shippers a problem

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PRIVATE CONTRACTS SMALL CUSTOMERS

• German Gas Heating
• Invest in gas furnace
• Commuter Railroads
• Invest in suburban residences
• Airline Frequent Flyer
• Volume discount at dominated hubs

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REGULATORY OPTIONS

• If durable, immobile investments
• If hard to negotiate individual contracts
• If hard to write complete contract
• If few institutional limits on opportunism

• Spot market
• Private long-term contracts
• Concession contract
• Discretionary regulation
• Public enterprise

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