In praise of
private
infrastructure
n economy depends on infrastructure to facilitate
the flow of goods, people, information and
energy. Accordingly, ports, roads, bridges, railways,
airports, communication networks, power lines,
waterworks and many other infrastructure systems represent
important inputs into an economy.
Poor infrastructure – either in terms of its quantity or quality
– not only increases costs but can literally bring an economy to
its knees. India and many other Asian nations have been severely
handicapped by poor infrastructure.
Even the US is not without infrastructure problems. For example,
the number of vehicle miles traveled in the US has doubled
since 1980, but the total road capacity has only increased by
6%. The result has been a dramatic increase in congestion costs
(lost time, extra fuel, etc.)
In the US and elsewhere, investments in infrastructure and
its maintenance are projected to be enormous. Indeed, for the
East Asia-Pacific and South Asia regions, the projected expenditures
on infrastructure investment and maintenance in the
2005-2010 period account for 6.6% and 6.9% of GDP, respectively
(see table).
A critical question: Should infrastructure be provided by the
private or public sector?
Adam Smith answered this question in the Wealth of Nations
(1776). He concluded as follows: “No two characters seem more
inconsistent than those of trader and sovereign,” since people are
more wasteful with the wealth of others than with their own.
He thought public ownership and administration were negligent
and wasteful because public employees do not have a direct
interest in the commercial outcome of their actions.
Comparative cost analyses of private versus public provision
of goods and services give support to the conclusion that private
firms are more cost-effective than public firms. Considerable
evidence suggests that the public cost incurred in providing a
given quantity and quality of output is about twice as great as
private provision. This result occurs with such frequency that it
has given rise to a rule-of-thumb: “the bureaucratic rule of two.”
With the private provision of infrastructure, however, there is
In the United States, you know an
economic problem is acute when it
commands an entire chapter in the
Economic Report of the President.
Issued in February, the 2008 report
contains an edifying chapter titled:
“The Nation’s Infrastructure.”
COURTESY OF MEDCO ENERGY
A P R I L 2 0 0 8 | GlobeAsia 165
a potential problem: introducing
and maintaining competition.
This potential problem can arise
because of the so-called natural
monopoly character of many infrastructure
projects.
In short, even if there are
no artificial barriers to entry, a
monopoly will likely emerge because
a single firm can produce
goods and services more cheaply
than multiple firms (multiple
ports, bridges, etc. at the “same”
location are not economically
feasible).
Opponents of infrastructure
provided by the private sector
are quick to raise the specter of
a monopoly but there is a way
to solve the natural monopoly
problem and introduce competition
into the provision of private
infrastructure.
It involves a system of competitive
bidding for privatelyowned
infrastructure franchises.
Though competition within
a market may be impossible, the
benefits of competition for that
market may be attainable.
So long as there is vigorous bidding for an infrastructure
franchise, the best of both worlds – avoidance of redundant facilities
together with competitive prices – can be had. In theory,
such a system could ensure that the favorable incentive effect
normally associated with private ownership and management
of a firm (i.e. that private owners will control costs, enhance efficiency,
etc. as a way of maximizing their profits) will actually
come about.
How does it work?
The key to the franchise bidding approach to natural
monopolies is the following: bidding for the monopoly franchise
should not be in terms of a sum to be paid for the franchise, but
in terms of the prices that the franchisee would charge and the
services the franchise would provide the public on award of the
right to be the exclusive supplier.
If the franchises were merely awarded to the bidder willing to
pay the highest price for this exclusive right, competition would
drive bids up to an amount equal to the present value of expected
future monopoly profits in the market.
This would transfer monopoly profits from the franchisee to
whatever authority granted the franchise in the first place, but
consumers would still pay monopoly prices.
Instead, an auction should be held in which the franchise is
awarded to whichever bidder promises the best combination of
price and quality to consumers.
Here, competition would drive bid prices down to competitive
levels for each possible level of service quality.
Theory is not necessarily reality, however. Indeed, some
scholars have expressed reservations about franchise bidding.
One set of concerns relates to the bidding process itself.
Selecting a winner (i.e., determining an optimal price structure
and mix of products) may be exceedingly complex, and
there is no guarantee that bidding will be truly competitive. For
example, new firms may be reluctant to bid on a franchise that
has expired when the previous franchisee is also in the bidding,
since the previous supplier is almost certain to be better informed
about actual cost and demand conditions than are its rivals.
Another set of concerns relates to the likely behavior of the
winning bidder during the term of the franchise contract. If the
contract is for a reasonably long term, there must be some formula
to allow for rate changes as costs, demands, and technologies
change over time—or renegotiation must be allowed.
If a formula approach is impractical and renegotiation allowed,
the need for some sort of agency similar to a regulatory
commission becomes apparent. Such an agency will also be
needed to police the franchise contract, since the agreement will
not be self-enforcing.
Further problems can arise as the end of the contract approaches,
as the franchisee may curtail maintenance operations
and under-invest in new assets, leaving “the next guy” to cope
with any resulting problems.
Agents
These are important but not intractable problems.
Three aspects (the difficulty of selecting a winning bidder, the
difficulty of specifying or renegotiating contracts, and the need
to police the contract) require the existence of some sort of “buyers’
agency” to represent consumers.
These buyers’ agents must be well-rewarded for monitoring
the terms of the franchise contract. France provides evidence
that highly paid civil servants can perform this task effectively.
However, critics of franchise bidding have asserted that such
an agency would simply be reduced to performing the same tasks
assigned to traditional government regulators – with the same
difficulties and potential for inefficiency, abuse and corruption
166 GlobeAsia | A P R I L 2 0 0 8
Perspective
– leaving consumers no better off than they are now.
This is not necessarily the case. The degree of technological
complexity and the swiftness of technological
change in the relevant industry are the crucial variables.
Selecting a winning bidder may be difficult where
technology has created myriad potential service options.
But where it is possible to specify a limited number of
service standards, awarding the franchise may not be
troublesome at all.
And where the pace of technological change is not
too rapid, it may be quite easy to agree on some sort of
formula for price increases, and the possibility of midcontract
renegotiation may never arise.
Furthermore, enforcing the contract also will be facilitated
in industries where the number of specified service standards is
relatively limited. These three factors make the water supply a
perfect example of an ideal candidate for franchise bidding.
The technology of water supply is well known and relatively
static, and specifications about service standards and quality are
readily formulable. All the critics’ qualms about the practicability
of franchise bidding recede in such a context.
The benefits of such a private system would be considerable.
Giving the winning bidder a monopoly franchise will ensure that
the firm is able to exploit all possible economies of scale in the
provision of service, while requiring bidders to compete on price
and service standards.
This will prevent the firm from using its market power to
overcharge or under-provide. Granting this monopoly franchise
to private owners will harness the incentives of these owners to
control costs efficiently in order to maximize profits.
To implement the system,
the government need only create
such a buyers’ agency with a
mandate to conduct the auction
and devise the contracts for the
construction, maintenance, or
operation of the facilities.
Once the franchise is granted,
enforcement of the contract can
itself be privatized (if enforcement
is not done by the agency).
An accounting firm, for example,
could be retained to audit
the franchisee and confirm that
the terms of the contract have
been observed.
To create additional incentives
for franchisees to maintain
and improve quality, contracts
could require the franchisee to
post a bond for the duration of
the franchise. This bond would be
forfeited to the contract enforcers
if the franchisee is found to be in
violation of the contract; it would
serve essentially the same function
as a “security deposit” on an apartment.
Once in place, the franchisee
will have every incentive to aggressively
control costs, adopt new
technologies, etc., since every dollar
of cost saved is an extra dollar of
profit earned.
If the firm’s managers are not attentive to cost control, the
firms’ profits will fall, share prices will decline, and the firm will
become a ripe target for takeover by owners seeking to reap the
gains which would result from turning out (or better motivating)
the inefficient management.
Most nations face daunting infrastructure problems. To
solve them, well-tested methods of private provision must be
embraced. Private infrastructure franchises that are properly
designed and strictly policed hold the key for infrastructure provision.
