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

Usual explanation: Economies of scale Cost/customer Number of customers But also requires: durable, immobile and costly investments by Infrastructure users, and Infrastructure suppliers SOURCES OF MONOPOLY POWER

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

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

TRANSACTION COSTS (Ronald Coase, Oliver Williamson, Douglas North) TRANSACTION COSTS: = Costs of negotiating and enforcing agreements Arise because: 1.Not omniscient: Hard to know every fact, anticipate every development 2.Not saints: Parties will behave opportunistically by withholding information Influence organization of economic activity

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

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

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

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)

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

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

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

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)

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

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

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

PRIVATE CONTRACTS: LARGE CUSTOMERS U.S. Freight Railroads 19 th 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

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

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