In Praise of Private Infrastructure

This article appeared in the April 2008 issue of Globe Asia.
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An economy depends on infrastructure to facilitatethe flow of goods, people, information andenergy. Accordingly, ports, roads, bridges, railways,airports, communication networks, power lines,waterworks and many other infrastructure systems representimportant inputs into an economy.

Poor infrastructure - either in terms of its quantity or quality- not only increases costs but can literally bring an economy toits knees. India and many other Asian nations have been severelyhandicapped by poor infrastructure.

Even the US is not without infrastructure problems. For example,the number of vehicle miles traveled in the US has doubledsince 1980, but the total road capacity has only increased by6%. The result has been a dramatic increase in congestion costs(lost time, extra fuel, etc.)

In the US and elsewhere, investments in infrastructure andits maintenance are projected to be enormous. Indeed, for theEast Asia-Pacific and South Asia regions, the projected expenditureson infrastructure investment and maintenance in the2005-2010 period account for 6.6% and 6.9% of GDP, respectively(see table).

A critical question: Should infrastructure be provided by theprivate or public sector?

Adam Smith answered this question in the Wealth of Nations(1776). He concluded as follows: "No two characters seem moreinconsistent than those of trader and sovereign," since people aremore wasteful with the wealth of others than with their own.

He thought public ownership and administration were negligentand wasteful because public employees do not have a directinterest in the commercial outcome of their actions.

Comparative cost analyses of private versus public provisionof goods and services give support to the conclusion that privatefirms are more cost-effective than public firms. Considerableevidence suggests that the public cost incurred in providing agiven quantity and quality of output is about twice as great asprivate provision. This result occurs with such frequency that ithas given rise to a rule-of-thumb: "the bureaucratic rule of two."

With the private provision of infrastructure, however, there isa potential problem: introducingand maintaining competition.This potential problem can arisebecause of the so-called naturalmonopoly character of many infrastructureprojects.

In short, even if there areno artificial barriers to entry, amonopoly will likely emerge becausea single firm can producegoods and services more cheaplythan multiple firms (multipleports, bridges, etc. at the "same"location are not economicallyfeasible).

Opponents of infrastructureprovided by the private sectorare quick to raise the specter ofa monopoly but there is a wayto solve the natural monopolyproblem and introduce competitioninto the provision of privateinfrastructure.

It involves a system of competitivebidding for privatelyownedinfrastructure franchises.Though competition withina market may be impossible, thebenefits of competition for thatmarket may be attainable.

So long as there is vigorous bidding for an infrastructurefranchise, the best of both worlds - avoidance of redundant facilitiestogether with competitive prices - can be had. In theory,such a system could ensure that the favorable incentive effectnormally associated with private ownership and managementof a firm (i.e. that private owners will control costs, enhance efficiency,etc. as a way of maximizing their profits) will actuallycome about.

How does it work?

The key to the franchise bidding approach to naturalmonopolies is the following: bidding for the monopoly franchiseshould not be in terms of a sum to be paid for the franchise, butin terms of the prices that the franchisee would charge and theservices the franchise would provide the public on award of theright to be the exclusive supplier.

If the franchises were merely awarded to the bidder willing topay the highest price for this exclusive right, competition woulddrive bids up to an amount equal to the present value of expectedfuture monopoly profits in the market.

This would transfer monopoly profits from the franchisee towhatever authority granted the franchise in the first place, butconsumers would still pay monopoly prices.

Instead, an auction should be held in which the franchise isawarded to whichever bidder promises the best combination ofprice and quality to consumers.

Here, competition would drive bid prices down to competitivelevels for each possible level of service quality.

Theory is not necessarily reality, however. Indeed, somescholars 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 structureand mix of products) may be exceedingly complex, andthere is no guarantee that bidding will be truly competitive. Forexample, new firms may be reluctant to bid on a franchise thathas expired when the previous franchisee is also in the bidding,since the previous supplier is almost certain to be better informedabout actual cost and demand conditions than are its rivals.

Another set of concerns relates to the likely behavior of thewinning bidder during the term of the franchise contract. If thecontract is for a reasonably long term, there must be some formulato allow for rate changes as costs, demands, and technologieschange 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 regulatorycommission becomes apparent. Such an agency will also beneeded to police the franchise contract, since the agreement willnot be self-enforcing.Further problems can arise as the end of the contract approaches,as the franchisee may curtail maintenance operationsand under-invest in new assets, leaving "the next guy" to copewith any resulting problems.

Agents

These are important but not intractable problems.Three aspects (the difficulty of selecting a winning bidder, thedifficulty of specifying or renegotiating contracts, and the needto police the contract) require the existence of some sort of "buyers'agency" to represent consumers.

These buyers' agents must be well-rewarded for monitoringthe terms of the franchise contract. France provides evidencethat highly paid civil servants can perform this task effectively.

However, critics of franchise bidding have asserted that suchan agency would simply be reduced to performing the same tasksassigned to traditional government regulators - with the samedifficulties and potential for inefficiency, abuse and corruption - leaving consumers no better off than they are now.

Expected Annual Investment Needs, 2005-2010

This is not necessarily the case. The degree of technologicalcomplexity and the swiftness of technologicalchange in the relevant industry are the crucial variables.

Selecting a winning bidder may be difficult wheretechnology has created myriad potential service options.But where it is possible to specify a limited number ofservice standards, awarding the franchise may not betroublesome at all.

And where the pace of technological change is nottoo rapid, it may be quite easy to agree on some sort offormula for price increases, and the possibility of midcontractrenegotiation may never arise.

Furthermore, enforcing the contract also will be facilitatedin industries where the number of specified service standards isrelatively limited. These three factors make the water supply aperfect example of an ideal candidate for franchise bidding.

The technology of water supply is well known and relativelystatic, and specifications about service standards and quality arereadily formulable. All the critics' qualms about the practicabilityof 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 thatthe firm is able to exploit all possible economies of scale in theprovision of service, while requiring bidders to compete on priceand service standards.

This will prevent the firm from using its market power toovercharge or under-provide. Granting this monopoly franchiseto private owners will harness the incentives of these owners tocontrol costs efficiently in order to maximize profits.

To implement the system,the government need only createsuch a buyers' agency with amandate to conduct the auctionand devise the contracts for theconstruction, maintenance, oroperation of the facilities.

Once the franchise is granted,enforcement of the contract canitself be privatized (if enforcementis not done by the agency).An accounting firm, for example,could be retained to auditthe franchisee and confirm thatthe terms of the contract havebeen observed.

To create additional incentivesfor franchisees to maintainand improve quality, contractscould require the franchisee topost a bond for the duration ofthe franchise. This bond would beforfeited to the contract enforcersif the franchisee is found to be inviolation of the contract; it wouldserve essentially the same functionas a "security deposit" on an apartment.

Once in place, the franchiseewill have every incentive to aggressivelycontrol costs, adopt newtechnologies, etc., since every dollarof cost saved is an extra dollar ofprofit earned.

If the firm's managers are not attentive to cost control, thefirms' profits will fall, share prices will decline, and the firm willbecome a ripe target for takeover by owners seeking to reap thegains which would result from turning out (or better motivating)the inefficient management.

Most nations face daunting infrastructure problems. Tosolve them, well-tested methods of private provision must beembraced. Private infrastructure franchises that are properlydesigned and strictly policed hold the key for infrastructure provision.

(For a full treatment of this topic, see: S. H. Hanke and S. J.K. Walters, "Privatizing Water Works", in: Prospects for Privatization,1987; and S. H. Hanke, "Privatization", in: The New Palgrave:A Dictionary of Economics, Vol. 3, 1987.)

Steve H. Hanke

Steve H. Hanke is a Professor of Applied Economics at The Johns Hopkins University in Baltimore and a Senior Fellow at the Cato Institute. He was advisor to former President Suharto in 1998.