Contestability, Complementary Inputs and Contracting: The

Case of Harbour Towage*

by

Joshua S. Gans and Stephen P. King

Melbourne Business School
University of Melbourne

First Draft: April 2002

This Version: 30th July, 2003

It has been argued that competitive tendering for contracts can be used to
overcome problems of natural monopoly and to make markets ‘contestable.’ The
recent Productivity Commission report into harbour towage in Australia noted
the potential benefits of competition for contracts. Using the example of harbour
towage, we investigate these claims when competitive tendering involves one
segment of a vertical production chain. We show that direct customer contracting
will not result in a perfectly contestable outcome if there is a complementary
input provider with market power. In particular, contracting involves a socially
sub-optimal service quality. We consider whether this situation improves when
customers delegate the contracting process. In the case of harbour towage, the
port authority is an obvious delegated agent for the shipping customers. But
delegation only improves the outcome from the customers’ perspective if the
authority is able to receive side payments from the towage operators. Such side
payments, a priori would appear to be against the interests of the customers. We
show, however, that side-payments help the port authority to overcome the
problems of market power, benefiting both the port authority and the customers.
Further, these contracting outcomes are socially preferred to the unregulated
outcome where port authorities and towage operators set prices and quality
independently. This analysis sheds light and generally supports the Productivity
Commissions recommendations. Journal of Economic Literature Classification
Numbers: L14, L50

Keywords. contestability, contracting, harbour towage, complementary inputs.

Two line summary: The paper examines and finds support for the PC’s recommendations
regarding contestability of harbour towage and the subtleties of regulating parts of a vertical
chain.

*
This research was partly funded by Adsteam Marine Ltd. The views expressed in this document do
not necessarily reflect those of Adsteam Marine and responsibility for all errors and omissions lies with
the authors. All correspondence to: Joshua Gans, E-mail: J.Gans@unimelb.edu.au.
I. Introduction

It is more than twenty years since the theory of contestability underwent

widespread development in economics. First presented by Baumol, Panzar and Willig

(1982, 1983), contestability and the possibility of perfectly contestable markets

promised reduced regulation for natural monopolies.1 A perfectly contestable market

will have second-best prices that are at least as good as direct regulatory intervention.2

But the assumptions underlying the original theory are strong and unlikely to hold in

practice (Spence, 1983; Martin, 1993; Dasgupta and Stiglitz, 1988). In particular,

perfect contestability requires that entry can occur without any sunk costs so that an

entrant can engage in ‘hit and run competition,’ stealing an incumbent’s customers

before the incumbent has time to react. Even the airline industry, originally feted as an

example of a highly contestable industry, was found not to behave this way in practice

(Baumol and Willig, 1986).

As Baumol, Panzar and Willig (1983) note, however, contestability has a close

relationship with earlier work by Chadwick (1859) and Demsetz (1968) regarding the

potential of competition for a market to substitute for competition in a market. Even if

a market involves a natural monopoly technology, if a potential entrant could contract

with (sufficient) buyers and steal those buyers from the incumbent whenever the

incumbent raised prices significantly above costs, then the threat of ‘competition for

contracts’ would discipline the incumbent. This theory also has limitations. If there

are many buyers, then the transactions costs involved in negotiating contracts and the

1
See also Baumol (1982) and Bailey (1981). The Economist (1998) surveys the role of contestability
and other ‘Chicago School’ theories in US antitrust practice in the 1980s.
2
The standard model of contestability involves a homogeneous product with linear pricing. Price
discrimination and contestability has recently been analyzed by Weichenrieder (1999).
 2

potential for retaliation by the incumbent, reduce any potential for competition

(Martin, 1993). Even if there are only a few large buyers together with a number of

smaller buyers, competition to contract the large buyers need not be socially desirable

(Gans and King, 2002).

Competitive tendering for the market is most likely to lead to socially efficient

outcomes if there is only a single buyer or where a single agent can act on behalf of

all buyers. This is the basis of franchise bidding, where the government acts as the

single agent and auctions the ‘right’ to be the monopoly provider to the firm willing to

set (subject to quality thresholds) the lowest price to customers. The government is

usually assumed to act in the interest of customers when awarding the contract.3

Harbour towage services also seem amenable to competitive tendering. For

relatively small ports, such as those in Australia, harbour towage involves a natural

monopoly technology. With this technology, it is efficient to have a single provider of

towage in each port.4 The customers are the various shippers who require towage

when their ships either enter or leave a particular port. While there are a large number

of these companies, they have a natural agent, the port authority. When maximising

its own profits,5 the port authority will want to ensure that towage services do not

deter shippers from using its port. Thus, the interests of shippers and port authorities

would appear to be aligned when considering towage. Further, the main capital

involved in towage – the tugs – is mobile, making it unlikely that an incumbent will

3
This leads to a second best outcome where the winning price equals average cost and exceeds
marginal cost. See Armstrong, Cowan and Vickers (1994) and Laffont and Tirole (1993) for brief
surveys.
4
“There is a consensus that low demand levels, combined with ‘lumpy’ investments (due to minimum
tug fleets needed to offer appropriate service levels) and economies of scale in towage operations,
mean that most, if not all, Australian ports can efficiently support only one provider of towage services
at a time” (Productivity Commission, 2002, p.xxvi, italics in original).
5
While some port authorities are private, others are government authorities. But those authorities that
remain government owned are fully corporatised, so that profit maximization is a reasonable
assumption about their behavior.
 3

have any significant advantage when bidding for an exclusive port contract, and

making robust competition for a contract likely.

The potential for competition for contracts to create a contestable market for

towage has been a key element of a recent legal case.6 It was also a central part of a

recent Productivity Commission (PC) inquiry into the regulation of harbour towage.

Until 19th September 2002, harbour towage in Australia had been subject to prices

surveillance in seven key ports.7 Under such surveillance, the Australian Competition

and Consumer Commission (ACCC) had to be notified of any price changes and

could assess whether the changes were justified.8 In early 2002, the Federal

Government asked the PC to examine the extent of competition in harbour towage.

The PC reported to the Federal Government in August 2002, with the final report

being publicly released in March 2003 (PC, 2002). The Federal Government has

accepted the PC’s recommendations, including recommendations that remove the

seven ports from prices surveillance (albeit subjecting them to limited monitoring by

the ACCC) and encourage port authorities to use competitive tendering to license

towage operators in their ports.

The PC found that potential entry (i.e., relatively low sunk costs) together with

the strong bargaining position of port authorities, can constrain the pricing of harbour

towage. “This means that actual entry or the potential for a contest for the provision of

towage services at a port is likely to provide the main market constraint on market

power of an incumbent operator.” (PC, 2002, p.xxx) The PC notes that competitive

6
See Gans, Hanks and Williams (2001) for a description of where the courts held that contestability
over contracts could secure competitive outcomes in harbour towage despite its natural monopoly
elements.
7
The ports declared for surveillance under s.21 of the Prices Surveillance Act, 1983, were Melbourne,
Sydney (Port Botany and Port Jackson), Newcastle, Brisbane, Freemantle and Adelaide.
8
This policy was introduced because of concerns about the extent of competition in those ports; all of
which have a single towage operator owned by Adsteam Marine Ltd. Adsteam is also the sole provider
of towage services in 31 of the other 45 ports around Australia.
 4

tendering for exclusive licences may offer a “means of selecting the towage provider

at a port … which, in principle, could promote efficient prices and quantities.” (PC,

2002, p.xxxix)9

While the market for harbour towage is potentially contestable through

contracting, it has two features that suggest caution. First, towage prices are only one

component of the costs facing shippers. Shippers also pay fees to other

complementary input providers, including stevedores, pilots and the port authorities

themselves. Even if the towage operator is appointed through a competitive tender,

the other suppliers of port services, such as the port authority, are not subject to any

direct competition. Thus, it is not clear whether improving the contestability of one of

a number of complementary inputs is beneficial or detrimental to the customers.

Second, if exclusive contracting for towage is organised by a port authority,

then this authority acts both as an agent for the shippers and as a provider of

complementary inputs to the towage companies. In this situation, it is far from

obvious that the port authorities will act in the best interests of the shippers. As the PC

notes, “[i]f port owners do not act in the best interests of ship owners, then tendering

by the port authority is unlikely to be the most appropriate method of choosing the

towage firm to supply the market at a particular port.” (2002, p.160)

In this paper we develop a simple model of a contestable market with

competition for contracts when the party who acts as an agent for the customers also

provides complementary inputs. This model allows us to address two key questions:

9
This said, the PC stops short of recommending the use of competitive tendering for exclusive towage
licences. “In short, competitive tenders for exclusive licences should neither be prescribed nor
proscribed by relevant jurisdictions. But they are an option, along with non-exclusive licences, which
ports should have the discretion to implement (or threaten to implement) provided appropriate
procedures and guidelines are in place …” (PC, 2002, p.xL, italics in original). At the same time, the
PC found that in some states there was a lack of certainty about the legal position of Port Authorities to
utilize competitive tendering to facilitate contestable outcomes.
 5

1. Is competitive tendering for one input desirable if other complementary

inputs are not subject to competition; and
2. Will a supplier of complementary inputs act in the customers’ interest
when designing a competitive tender?

We examine these questions within the specific context of harbour towage, although

the model is clearly more generally applicable.

The model, developed in Section II, considers both the price and quality of

towage services. This allows us to consider (i) the effect of competitive tendering on

the price of towage; (ii) the effect of competitive tendering on the quality of towage

services and (iii) the effect of competitive tendering on the price of complementary

inputs and, thus, on the total price paid by shippers for port services and on the social

surplus generated by port services.

Before we can consider the potential benefits of competitive tendering, we

need to consider the alternatives. We do this in sections III and IV. Section III

presents two benchmark cases. The first is the social second-best linear pricing

outcome when both the port authority and the towage operator earn minimum profits.

This is the ‘constrained second-best’ outcome associated with a perfectly competitive

market. The second benchmark considers an integrated port/towage operator. This

allows us to consider what distortions, if any, are created by the arms-length

arrangement between the providers of complementary inputs. Section IV considers

the ‘unregulated’ outcome in the absence of any tendering or regulation. This

provides us with a ‘market’ benchmark for the natural monopoly services.

Section V presents the main results. We consider three models of competitive

tendering to create a contestable market in towage. We show that direct customer

contracting, of the type usually envisaged by the franchise contracting literature, will

not lead to the ‘constrained second best’ outcome. In particular, the contract quality
 6

will be too low. This is because of the market power of the complementary input

provider. This market power is not eliminated when the contracting process is either

partially or fully delegated to the port authority. Thus, simple delegation creates no

additional conflict, but does not improve the outcome. This situation changes,

however, if the delegated authority is able to receive side payments from the towage

operators. Such side payments, a priori would appear to be against the interests of the

customers. But we show that side-payments help the port authority to overcome the

problems of market power, benefiting both the port authority and the customers.

Section VI compares the tendering outcomes to the unregulated outcomes. We

show that, while competitive tendering does not lead to the constrained second-best

outcome, it still leads to greater social surplus than unregulated interaction between a

single port authority and a single towage company. Finally Section VII concludes.

This paper contributes to the economic literature in two ways. Most obviously,

it provides a framework to analyse alternative government approaches to harbour

towage. More generally, it considers the interaction between contestability in a market

and contracting. While a market may be made ‘more contestable’ through competition

for contracts, the obvious agent to control such contracting on the customers’ behalf

will often be a complementary supplier. This paper extends the literature on market

design by providing a formal analysis of the outcomes in this situation.

II. Model Set-Up

We consider a simple formal model of the interactions between a Towage

Company (T) and a Port Authority (A). A includes the pilots, stevedoring, berthing

and any other port functions not supplied by T. For simplicity, we treat all these non-

towage functions as if they were controlled by a single profit maximising entity.

 7

T and A supply complementary products to shippers. Due to the different and,

generally, non-substitutable nature of these products, we assume that a shipper

requires a fixed amount of towage services from T and other port services from A. T

and A independently price these services and we denote the prices of these services by

p and r respectively. Thus, a ‘representative ship’ that wishes to use the relevant port

needs to pay p dollars for towage services and r dollars for other complementary port

services. The total price for port services to the shipper (including towage) is p + r.

Demand for port services depends on both the total price of port services and

the quality of those services. The quality of towage, pilot services and other port

services all matter to shippers. However, the focus here is on the towage companies so

we will focus on their service. We denote the service level of T by s. We assume a

simple linear demand for shipping services. This is convenient as it allows for simple

numerical analysis. However, our key results are robust to more general well-behaved

demand functions.

Demand for port services by shippers is given by Q = a + s − ( p + r ) where Q

is the quantity of services sold by the port and a is a constant representing the

intercept of the demand curve.

The quality of towage services generally relates to fixed costs such as the

standing number of tugs available (Adsteam, 2002). The greater the number of tugs in

a port, the shorter will be the expected waiting time for any ship wishing to enter or

leave the port. Thus, we denote the cost of service level s by a fixed charge, F(s). The

lowest level of service is simply set to 0 with F(0) = 0 and we assume that the

marginal cost of increased service is positive and increasing so that F ′( s) > 0 and

F ′′ ( s ) ≥ 5
9 for all s. Further for any finite number, n, we assume that there is a finite
 8

level of service, sn such that F ′( sn ) ≥ n .These assumptions ensure that the second

order conditions for the profit maximizing service level are always satisfied. So long

as F ′(0) is sufficiently small they also ensure that an internal solution will always

exist.10 Further, given our assumption on F ′′ it is easy to show that at all s,

F ( s ) < F ′( s ) 2 . This condition, while not necessary for our analysis, allows us to

unambiguously order the level of service under a variety of industry outcomes.11

Both T and A also have variable costs for additional ships. For simplicity, we

assume that the marginal cost of providing services to an additional ship is constant.12

We denote these marginal costs by c and θ for T and A respectively. To ensure that

there is always some demand for the port services, we assume that a > c + θ. The

profit of T and of A respectively are given by π T = ( p − c)Q − F ( s ) + t and

π A = (r − θ )Q − t ; where t are potential transfers made between A and T.

III. Benchmark Cases

We begin by establishing two benchmarks for later analysis. These are the

constrained second-best benchmark and the integrated port benchmark. These

benchmarks will differ in our framework because the port as a whole faces a

10
These assumptions are slightly stronger than usual. This is because service raises both demand and
cost, so it is important to constrain the problem so that it is not optimal (i.e. either profit maximizing or
socially desirable) to always offer an arbitrarily high level of service. This could occur if demand rises
‘faster’ than costs as service increases. Our assumptions rule out this possibility at sufficiently high
levels of service.
To see that this condition holds note that F (0) = 0 and increases at rate F ′ while F ′ is positive
11 2

when s = 0 and increases at rate 2F ′F ′′ which exceeds F ′ so long as F ′′ exceeds one-half. By

assumption, F ′′ ≥ 95 . This condition is satisfied for a variety of simple functional forms, such as
F ( s ) = s 2 and F ( s) = e s − 1 .
12
This is a reasonable assumption in the Australian context as most ports operate at a level where
towage services have significant idle time (PC, 2002).
 9

downward sloping demand. Thus, our model allows for imperfect competition

between ports as noted by the PC in its report.

(i) The social optimum under linear pricing

With a single input provider, perfect contestability leads to a second best

outcome where the firm sets the optimal quality and charges a linear price that just

covers average costs. In our model with complementary input providers, the

equivalent benchmark involves setting the total price for port services to the lowest

possible level to just cover costs and then setting service quality to maximise social

surplus.13 For any service level, s, let z be the minimum total price that allows both A

and T to cover costs. Thus, z = c + θ + FQ( s ) where the total quantity purchased, Q

depends on the price z. Thus, Q = a + s – z. Noting that the social welfare will just be

the welfare of shippers, given by the area under their demand curve, the optimal

(a + s − z)
2
pricing and service levels are found by setting s and z to maximise 1
2

subject to F ( s ) = ( a + s − z )( z − c − θ ) . The first order conditions are:

a + s − z + λ ( z − c − θ ) − λ F ′( s ) = 0 (1)

−( a + s − z ) − λ ( z − c − θ ) + λ ( a + s − z ) = 0 (2)

Adding (1) and (2) gives z = a + s − F ′( s) . Substitution back into the zero profit

constraint then gives the socially optimal service quality implicitly defined by s*
*
where a − c − θ = F ′( s* ) + FF′((ss*)) − s* .

13
This is a constrained second-best optimum in the sense that it involves linear pricing and requires
pricing such that A and T cover their costs. Because investment in service is a sunk cost, an
unconstrained social optimum would involve the total price, z = c + θ (i.e. marginal cost equals price)
with a service level implicitly defined by a − c − θ = F ′( s ) − s . Note that this unconstrained level of
service is higher than the second-best social optimum but is inconsistent with positive profits for any
linear prices in the absence of a government subsidy.
 10

(ii) Integrated Port and Towage Operations

Given the demand for port services, an integrated port will seek to maximise

the sum of profits. As it is the sum of prices, p + r that matters for demand, the

integrated port will simply set this sum to maximise joint profits. For a given service

level, the optimal prices under integration (I) are pI + rI = 1

2 ( a + s + c + θ ) . The profit

maximising service level is implicitly defined by sI such that a − c − θ = 2 F ′( sI ) − sI .

Note that by our assumptions, this optimal service level is well defined and unique.

( a + sI − c − θ ) − F ( sI ) .
2
The integrated port profit is given by π I = 1
4

(iii) Comparison

It is clear that, for any given level of service, the price charged by the

integrated port/towage company will exceed the second-best price, otherwise the

integrated firm would make no profits. But this does not mean that the actual price is

higher. Rather, this depends on the service level and, as proposition 1 shows, the

integrated firm produces a lower quality when compared to the constrained social

optimum.

Proposition 1: The constrained socially optimal level of towage service (s*) strictly
exceeds the level of towage service provided by an integrated port/towage firm (sI).

PROOF: The two service levels are implicitly defined by

*
a − c − θ = 2 F ′( sI ) − sI and a − c − θ = F ′( s* ) + FF′((ss*)) − s* . The left hand sides of
these equations are equal and, as noted above, F ( s) < F ′( s ) 2 . Thus
*
a − c − θ = F ′( s* ) + FF′((ss*)) − s* < 2 F ′( s* ) − s* . Noting that F ′′ > 0 , this means that
sI must be strictly less than s* .
 11

IV. Unregulated Outcomes

Before considering whether competitive tendering will improve the market for

towage services, we need to consider what will occur in the absence of tendering or

any formal regulation. This section considers the unregulated outcomes.

In the absence of any regulation or tendering, an incumbent port authority will

negotiate with an incumbent towage company. Practice in unregulated ports in

Australia might be best described by the following process: First, A and T negotiate

over service levels that T will provide, then, A and T independently set the prices for

their services. The outcome will depend on the bargaining process and relative

bargaining strengths of the two parties. At one extreme, it can be argued that the Port

Authorities (and pilots) unilaterally impose significant service requirements on the

towage operators (Adstream, 2002). At the other extreme, T can unilaterally set

service levels. These two extremes represent the ‘outer limits’ for bargaining. Other

bargaining solutions will occur between these extremes.

In each situation, given the agreed service level s, A and T will independently

set prices to maximise their individual profits. The Nash equilibrium prices can be

determined by simultaneously maximising the two profit functions π T and π A . The

optimal prices are given by p = 13 ( a + s + 2c − θ ) and r = 13 ( a + s + 2θ − c ) . The total

price for port services is given by r + p = 13 ( 2a + 2 s + c + θ ) . It is easy to confirm that

this price exceeds the price that would be charged by an integrated port given the

same service level. This is a standard result whenever two firms independently price

complementary inputs (Economides and Salop, 1992).

 12

Substituting these prices back into the profit functions, we see that for a given

level of service π T = 19 ( a + s − c − θ ) − F ( s ) and π A = (a + s − c −θ )

2 2
1
9
. We are now

able to consider the level of service.

(i) Service when the Port Authority has all bargaining power

Suppose that A is able to set the service level for T. Note that A’s profit is

increasing in service. In particular, because A can demand higher service and gains

the benefit of this service through increased demand, but does not have to pay directly

for that service, A will demand the highest feasible level of service subject to the

constraint that T cannot earn negative profits in the long-run; i.e., A will demand

( a + sA − c − θ )
2
service level sA such that π T is just driven to zero or 1
9 − F (sA ) = 0 .

This service level may be higher or lower than the integrated port service level

(and hence higher or lower than the social first-best service level). Two offsetting

effects drive this ambiguity. Due to its bargaining power, A raises the service level as

far as possible – even above the integrated service level. But the towage company’s

profits are reduced due to the negative pricing externality between the complementary

inputs, limiting the ability to raise quality – possibly below the integrated service

level.

The tendency for A to require over-servicing can be socially wasteful, in the

sense that it uses up all the profits of T for what might be little social return. In

particular, A has an incentive to demand improved service even if the marginal cost of

that service is large compared to the marginal benefit to the customer. This can be

seen by noting that the service level does not depend on the marginal benefits and

costs of improved service.

 13

(ii) Service when the towage operator has all bargaining power

In this situation, T will unilaterally set sT to maximise its own profits, π T .

Differentiating this means that the service level is implicitly given by

a − c − θ = 92 F ′( sT ) − sT . It is clear that this level of service is below the level that

would be offered by an integrated port facility.

The outcome here reflects a standard free-rider problem with complementary

inputs. If one producer of a complementary input raises quality then they increase

demand for both their own input and the complementary input. However, it is only the

return from own sales that raises their profit. Each firm will tend to ignore the spill-

over to the other firm’s profit in their quality decision and as a result too little quality

is produced.

(iii) Outcomes for service negotiation

The service levels s A and sT represent the extreme outcomes. In general

negotiation between T and A will lead to intermediate levels of service. There is likely

to be tension between T and A over service levels. T will wish to lower service levels

in general while A will wish to raise service levels. For example, A will tend to want T

to have more tugs available. They may wish to have a level of availability that is

wasteful from a social perspective.

While there are a range of bargaining outcomes that are possible, two

particular outcomes are worthy of closer attention. First, suppose that A and T could

set side payments when bargaining over the quality of towage service. In that

situation, they will coordinate on the level of service that maximises the joint profits

π T + π A , subject to the independent setting of prices. The firms will set transfers t to

share profits according to their bargaining power. In this situation, the co-operative
 14

service level will be implicitly defined by a − c − θ = 94 F ′( sC ) − sC . Note that this level

of service is below that associated with an integrated port/towage firm.

Second, consider the outcome that maximizes social surplus subject to the

bargaining process. This service outcome will provide a useful point of comparison as

it reflects the best unregulated outcome for society. It is straightforward to show that

social surplus in the unregulated outcome is given by 5

18 (a + s − c − θ ) 2 − F ( s ) .14 The

optimal unregulated service level is implicitly defined by a − c − θ = 95 F ′ ( sU ) − sU .

This exceeds the level of service under an integrated port/towage provider. This said,

the social optimum does not consider whether this outcome is feasible or not for the

towage operator. If sU > s A then the socially optimal service level will not be feasible

and the best unregulated service level is when the towage company makes no profit.

Figure 1 summarises the potential range of service levels when these are

negotiated between A and T. The lowest level of service will be when T can

unilaterally set the service level. The highest service level involves A unilaterally

setting the service level. As drawn, this level is above the integrated port service level.

Also, as drawn, the unregulated service level that maximises social welfare is feasible

so that it results in positive profits for the towage operator. It should be noted that the

higher the negotiated service level, the higher the total price of port services paid by

shippers.

14
Given our assumptions on F ′′( s ) , this is a concave function in s.
 15

Figure 1: Equilibrium Service Levels

sT sC sI sU sA Service
Level

Range of negotiated service levels

(iv) Summary

In summary, if the towage operator and the port authority simply bargain over

service quality and then unilaterally set prices, a wide variety of outcomes is possible.

At one extreme, the port authority may push for a socially excessive level of quality.

At the other extreme, the towage company will prefer a low service level, below that

of an integrated port/towage company and below the service level that would

maximize joint profits. If the towage operator and the port authority can negotiate

service levels with side payments then we would expect service to be set at a lower

level than with an integrated port/towage operation.

The analysis in this section reflects the status quo at those Australian ports that

have not been subject to either prices oversight or competitive tendering for towage. It

suggests that for these ports service levels are unlikely to be set at either the

constrained second-best optimal level or at the unregulated level that maximises

social welfare. This said, the exact service level will depend on the bargaining

between the incumbent towage operator and the port authority. Further, for any level

of service, the prices charged for port services in total exceed those set by an

integrated towage/port monopoly. In brief, our results strongly suggest that these ports

will not be operating in a socially efficient way.

 16

V. Contestability and Competitive Tendering

We now turn to the main issues to be examined in this paper. Given the

presence of (non-contestable) complementary services provided by the port authority,

does competitive tendering for towage directly by the customers benefit those

customers? In particular, can it lead to the constrained second-best optimal outcome

usually associated with a perfectly contestable market? Further, if the customers

cannot directly tender for towage services but can only indirectly tender using the port

authority as an agent, how does this alter the outcomes of the tender process?

Our analysis proceeds in three steps. Initially we consider standard

competitive tendering by the customers, ignoring any transaction or coordination

costs between customers. We then consider the delegation of tendering to the port

authority in two stages. First, we consider the situation where the port authority can

unilaterally set the quality of towage services prior to a competitive tender by

customers on the price of those services. We then allow the port authority to tender

over both price and quality with towage operators. This approach allows us to

separate price effects from quality effects, to determine if and on what dimension the

interests of the port authority will diverge from those of the shippers.

(i) Contestability through direct customer contracting

If the relevant port is dominated by a few large customers (e.g., ship owners,

exporters and/or importers), then those customers could either threaten to sign

contracts with an alternative towage company to facilitate entry or could initiate a

competitive tender for towage services. There has been at least one example of such

entry in Australia (in Newcastle). Such contracting potentially makes the market for

towage services fully contestable.

 17

Under competitive tendering towage prices must equal cost. Denote this price

by zT where zT = c + FQ( s ) . Thus, the service level will feed directly into the contracted

towage price. However, the customers must also purchase complementary port

services as well as towage, and they know, given the cost and quality of towage, that

A will set the price of other port services to maximise its profit. Thus,

r= 1
2 ( a + s − zT + θ ) .
With direct customer tendering, towage companies will bid on the basis of

both price and quality to customers. The winning contract will provide an optimal

level of service from the customers’ perspective given the pricing behaviour of A. The

customers will seek to maximise their total surplus. Noting that Q = a + s − r − zT , the

( a + s − zT − θ )
2
contestable contract will set s and zT to maximise 1
8 subject to

1
2 ( zT − c )( a + s − zT − θ ) = F ( s) . This is solved in an analogous way to the second-

best problem presented above. Thus, we find that the contestable level of service is

implicitly defined by a − c − θ = F (s)

F ′( s ) + 2 F ′( s) − s .

Proposition 2: With a complementary input producer, the equilibrium quality of

service under a competitive tender is less than both the constrained socially optimal
service level and the service level associated with an integrated firm.

PROOF: This directly follows from the equations for s* and sI. Thus,
* *
a − c − θ = F ′( s* ) + FF′((ss*)) − s* < 2 F ′( s* ) + FF′((ss*)) − s* so that the fully contestable
service level is below the constrained socially optimal service level. Similarly,
a − c − θ = 2 F ′( sI ) − sI < 2 F ′( sI ) + FF′((ssII )) − sI so that the fully contestable
service level is below the integrated service level.

Proposition 2 shows that when there are complementary input providers,

contestability for one input will lead to an under-provision of service quality for that

input. This distortion arises due to the market power of the other input provider. Here

A has an incentive to raise price even though this reduces demand. Knowing this, the
 18

customers themselves prefer to invest less in towage service levels. This service will

be used over a relatively smaller quantity due to the behaviour of A, so that it is not

desirable to invest as much in service levels.

Proposition 2 has strong consequences for claims that competitive tendering

can lead to second-best contestable outcomes. Such outcomes will not arise if there

are complementary input providers who are imperfectly competitive.

(ii) Contestability with pre-set service

Will having the port authority act as a delegated agent improve or worsen the

outcome of competitive tendering? To begin, we focus on quality. Suppose that A sets

service quality before the customers tender for the provision of towage services. As

before, the final quantity purchased by the customers will be Q = a + s − r − zT and A

will set its price, after zT is determined, at r = 1

2 ( a + s − zT + θ ) . Thus, the quantity of

towage purchased given service level s is given by Q = 1

2 ( a + s − zT − θ ) . Profit for A

( a + s − zT − θ )
2
is given by π A = 1
4 . A will set the level of service to maximise its

profit subject to the zero profit constraint for T, 1

2 ( zT − c )( a + s − zT − θ ) = F ( s) . But
solving this optimisation problem gives the same level of service as under the fully

contestable contract.

In our model, delegation of service determination to the complementary input

provider leads to no conflict with the customers. This can easily be seen by comparing

the customers’ objective function and A’s profit; the latter is simply twice the former.

This exact relationship is driven by the linear demand assumption of our model.

However, the basic principle – that under competition for towage contracts there is

limited conflict between A and the customers over service standards – is more general.
 19

Customers wish to set a level of service quality to maximise consumer surplus, taking

the cost of increased service into account. A also wishes to maximise consumer

surplus in the sense that through its own pricing policies it will turn some of that

surplus into profit. A has no incentive to either under-provide service or over-provide

service as this harms customer benefits and, as such, harms the authority’s ability to

seize profits from customers.

(iii) Delegated competitive tendering

Finally, suppose that the complete tendering process for towage is delegated to

the port authority. This is the most likely outcome for most Australian ports under the

PC recommendations. Firm A will call for tenders from towage companies based on

price and quality. Because of economies of scale we expect that there will only be a

single towage operator chosen through the tender and operating at the port.

Following the standard contestability assumptions and limiting the tender to a

service quality and a linear price to be charged to shippers, the delegated tender will

be identical to the direct customer tender, in the absence of any transaction costs. In

other words, delegation of the contracting process by the shippers to the port authority

creates no additional distortion. This immediately follows by comparing the port

authority’s profit function and the shippers’ surplus. A’s profit is simply a multiple of

consumers’ surplus. The logic of the full delegation result is the same as for partial

delegation. In our model, the port authority wants to set the towage prices and quality

to maximise consumers’ surplus as this allows it to maximise its profits.

Proposition 3a. With linear pricing and no side-payments between T and A, the
outcome under direct customer competitive tendering, partially delegated tendering
and fully delegated tendering are identical.

Fully delegated tendering, however, also raises the possibility of side-payments

between the port authority and the successful tender. Initially such side payments
 20

might appear undesirable. After all, the port authority should be acting in the

shippers’ interest, and any potential side-payment from a towage company would

appear to undermine this delegated interest. But, in fact, the opposite is true.

Suppose that A can write any contract with a towage operator, including any

form of non-linear transfer payments between A and T and any price p to be charged

to shippers. Then the outcome of the tender process will be identical to the outcome of

an integrated port. Competition between towage operators for the license to operate

will eliminate T’s profit. Further, A can simply set lump-sum transfers to or from the

successful company to ensure that its profit is zero with the desired service level and

towage prices. As such, A can effectively directly set p, r and s. Further, maximising

its own profit is the same for A as maximising joint profits, given that T’s profit is

zero. Hence, the tender process will lead to an outcome identical to that of an

integrated port. As with the integrated port, the specific prices p and r cannot be

determined although the sum of these prices, p + r and the level of service s are all

well-defined.

Proposition 3b. With linear pricing for shippers and side-payments between T and A,
the outcome under delegated tendering is the same as an integrated port/towage
company, and results in a higher level of service than in the absence of side-
payments.

In the absence of side-payments, the interaction between the port authority, the

towage companies and the shippers results in prices that are too high and quality that

is too low. By allowing the port authority to act as a delegated agent for the shippers

and to receive side-payments from towage company, the conflict between A and T is

eliminated, benefiting both the port authority and the shippers.

The propositions presented here have strong implications for contestability

and competitive tendering. In particular, the conflict between complementary input

 21

producers dominates the competitive benefits of competitive tendering for one input.

From the negative perspective this means that at best competitive tendering will result

in the same outcome as integration and monopoly provision by A and T. However, it

can lead to worse outcomes. From the positive perspective, however, this means that

if integration between A and T is impractical for some reason, then delegated

competitive tendering can recover all the competitive advantages of integration. For

Australia, where port authorities are often government owned while towage

companies are private with operations spreading over numerous ports and countries,

integration is unlikely. In this case, delegated tendering can provide important

competitive benefits.

VI. Is Competitive Tendering Better than the Unregulated

Outcome?

We have shown that competition for contracts does not result in a constrained

second-best outcome. But is it better than the unregulated market outcome? As

already noted, for any given service level, total port pricing will be higher in the

unregulated market than under an integrated outcome, and thus under full delegated

contracting. Service quality, however, may be higher or lower in the unregulated case,

potentially making any comparison ambiguous.

To allow for comparison, consider both the joint profit maximising and the

social welfare maximising outcomes under unregulated bargaining. The joint profit

maximising service level sC is less than the integrated service level sI . Proposition 4

compares social surplus under these two outcomes.

Proposition 4: The level of social surplus under delegated competitive tendering for
towage with linear pricing for shippers and lump-sum side-payments between T and
 22

A, is greater than the level of social surplus at the unregulated market outcome with
lump-sum side-payments between T and A.

PROOF: Recall that 5

18 (a + s − c − θ )2 − F ( s )
is social surplus in the
unregulated situation and this is concave by our assumptions on F ′′ with a
maximum at sU , sU > sI > sC . Thus, in the unregulated outcome, a service
level of sI leads to a greater level of social surplus than a service level of sC .
Further, note that for any level of service, if r + p > c + θ then social surplus is
decreasing in the total price. Finally, recall that given the service level the total
price of port services in the unregulated outcome exceeds the total price under
integration. Thus the integrated outcome with service level sI has a higher
level of social surplus than the unregulated outcome with service level sU ,
which in turn has higher social surplus than the unregulated outcome with
service level sC . The proposition immediately follows.

Proposition 4 shows that competitive tendering can increase social welfare compared

to the unregulated outcome when the towage company and port authority can make

side-payments. However, if in the unregulated situation, such side-payments are not

possible, say due to standard competition laws, then the outcome is less certain. In

particular, the level of service in an unregulated outcome can exceed that under

delegated contracting, so that while the unregulated outcome involves higher prices, it

may also have higher towage service levels. The trade off will depend on (i) the

comparison between the integrated service level sI and the socially optimal

unregulated service level sU , and (ii) on the relative bargaining power of T and A and

hence how close the unregulated service level is to the optimal level sU .

Even if unregulated bargaining leads to service level sU , contracting may be

preferred. But this will depend on the specific form of F. For example, suppose

F ( s ) = s 2 . This simple quadratic cost function satisfies all our assumptions. In this

situation, sI is equal to 1
3 (a − c −θ ) with social welfare under delegated tendering

equal to ( a − c − θ ) . In contrast, sU equals (a − c −θ )

2 5
13 with social surplus equal to
 23

(a − c −θ )
2
65
169 . Clearly the delegated tendering outcome is socially preferred to the

unregulated outcome in this situation.

In summary, while in theory an unregulated market outcome can be socially

preferred to delegated tendering, this is unlikely to be the case, particularly if either T

and A can make side-payments when bargaining over service or if the towage operator

has significant bargaining power so that service levels are low.

VII. Conclusions

This paper has used the example of harbour towage to extend the theory of

contestability and competitive tendering when there are complementary inputs. When

there is imperfect competition in the provision of a complementary input, creating a

perfectly contestable market for a natural monopoly input provider will not lead to the

constrained second-best social outcome. Thus it will not lead to the usual ‘perfectly

contestable’ outcome. In fact, within our framework, where the complementary input

provider is also a monopoly, the best outcome that can be achieved by competitive

tendering is equivalent to the outcome under a single integrated monopoly input

provider. In other words, at best, contestability in one input removes the problem of

over pricing and under servicing due to complementary inputs. However, this only

occurs under delegated tendering where the delegated agent can accept side-payments

from the successful tender.

While delegated competitive tendering does not create a perfectly contestable

market outcome, this does not mean that it is undesirable. Delegated tendering will

still be preferred to the unregulated interaction between two complementary input

providers, particularly when these interactions allow for side-payments.

 24

In this sense, our analysis in this paper supports the findings of the PC in its

report on harbour towage. The PC recommends delegated competitive tendering as

one possibility but is cautious in its advocacy. Given our results, this caution is well

founded. Delegated competitive tendering need not improve social surplus and is

unlikely to achieve a constrained second-best outcome. Further, our analysis suggests

that if delegated tendering is used to make the market for towage contestable, then the

widest possible delegation is needed. In particular, towage companies should be

allowed to make side-payments to the port authority, as such side payments help the

authority to internalise the external pricing effects between the complementary inputs.

While our model is applied to harbour towage, the lessons are clearly more

general. Tendering has often been claimed as a way to improve contestability and

increase customers’ surplus. Given the co-ordination costs of direct customer

tendering, delegated tendering is often required for real world implementation. Our

analysis shows that any jump from standard contestability theory to the outcomes of

delegated tendering needs to be treated with caution and scepticism. Formal analysis

is needed to make sure that the interests of the customers and the delegated authority

are aligned and to design the tender process to ensure socially desirable outcomes. In

particular, a poorly designed delegated tender may lower, not raise, customers’

benefits and social surplus.

 25

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