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Franchise Contracts natural monopoly

At the end of the 1970’s, a wide economic process of privatisation and deregulation has spread over Europe and most of the world. However, in most economies, certain industries have been kept nationalised longer than others have. A large part of those industries had in common to deal with utilities such as electricity, gas… and more generally to be in position of natural monopoly. Baumol defines natural monopoly as “an industry whose cost function is such that no combination of several firms can produce an industry output sector as cheaply as it can be provided by a single supplier”. Basically, it means that for a specific industry, a single supplier will be more efficient than several will. Natural or not, the problem remains the same. Large private monopolies usually end up using their market power to produce below the socially efficient level and therefore are not allocative efficient. In addition to that, price and output can be expected to diverge to a greater extent from their competitive levels the fewer the firms that produce the product for the market. These problems, combined with the privatisation trend, have pushed the economists to search an alternative solution to the simple privatisation.

On the whole, it is not so much franchising itself that is criticised but the way it is being done.

Operating franchises allow the firm in charge of the market to use the capital owned by the state to produce. Inefficiencies arise when the agents controlling these assets have no incentives to minimise the costs and therefore will tend to satisfy any need expressed by the company. The other burden borne by the regulators is the maintenance and the replacement of the capital. There again, there is little incentive for the company to treat the capital well and it may use it so intensely that the life of the capital will be shortened, and inversely, the state might be reluctant to improve the capital without a guarantee of performance. The main problem of this form of franchising is the potential conflicts that could arise between the partners.

Beside these two bidding processes, there are two forms of franchise contracts that recall the main problem of the natural monopoly, which is the cost to enter the market. The heavy initial investment required gives the incumbent firm a real advantage over other potential new entrants as firms are generally reluctant to pay for a capital, which will become a sunk cost if it loses the franchise at the end of the contract. The two forms of franchising contract are owning or operating, owning and operating referring to the initial investment required to enter the market.

The bidding process: collusion and advantage of the incumbent franchisee. Without competition, the bidding process has no point of being. The bidding process must be competitive and attract a sufficient number of bidders so that, as Demsetz writes, the costs of collusion outweigh the costs of competing.

Some topics in this essay:
Stigler Posner, , natural monopoly, bidding process, length contract, competition market, franchising contracts, moral hazard, incumbent franchisee, moral hazard adverse, element competition market, firm charge market, specialised skilled, alternative solution, main natural monopoly, poor performance, hazard adverse selection,