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ALTERNATIVE REGULATORY STRATEGIES AND THE ROLE OF PRIVATE CONTRACTS

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. SOURCES OF MONOPOLY POWER.

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ALTERNATIVE REGULATORY STRATEGIES AND THE ROLE OF PRIVATE CONTRACTS

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  1. 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

  2. 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

  3. Classic example: Municipal piped water Street with 2 small pipes Street with 1 large pipe

  4. Durable, immobile, and costly investments: • Make investors vulnerable to opportunistic behavior by others • Are common throughout economy—not just infrastructure • Usually solved by long-term private contracts

  5. 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

  6. WHO MANAGES PRODUCTION? Independent suppliers Purchasing firm Buy on spot market Make internally (vertical integration) ANALOGY TO PROCUREMENT“MAKE OR BUY”

  7. 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

  8. WHO MANAGES PRODUCTION? Independent suppliers Purchasing firm Buy on spot market Classical contract Relational contract Make internally (vertical integration) INTERMEDIATE OPTIONS

  9. 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)

  10. Spot market Classical contract Relational contract Make internally If relationship specific investments important If hard to write complete contract If few extra-contractual limits on opportunism PROCUREMENT OPTIONS

  11. WHO DECIDES? (PRICE & QUALITY) Markets Politics Spot markets Public enterprise REGULATORY OPTIONS

  12. WHO DECIDES? (PRICE & QUALITY) Markets Politics Spot market Private long-term contracts Concession contract Discretionary regulation Public enterprise REGULATORY OPTIONS

  13. 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”)

  14. 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

  15. DISCRETIONARY REGULATION PRO: • Flexibility to cope with unforeseen CON: • Technically difficult (information asymmetry) • Risk of regulatory “capture”

  16. 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

  17. 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

  18. 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

  19. Spot market Private long-term contracts Concession contract Discretionary regulation Public enterprise If durable, immobile investments If hard to negotiate individual contracts If hard to write complete contract If few institutional limits on opportunism REGULATORY OPTIONS

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