Transport Policy 18 (2011) 299–306

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Transport Policy
journal homepage: www.elsevier.com/locate/tranpol

Some lessons from incentive theory: Promoting quality in bus transport

Manuel González-Dı́az a, Ángeles Montoro-Sánchez b,n
a
University of Oviedo, Departamento Administración de Empresas, F. Económicas, Avda. del Cristo, s/n, 33006 Oviedo, Spain
b
Complutense University of Madrid, Departamento Organización de Empresas, F. CC. Económicas Empresariales, 28223 Pozuelo de Alarcón, Madrid, Spain

a r t i c l e in fo abstract

Available online 15 October 2010 While service quality is an important problem in bus transport services, few transport authorities have
Keywords: considered the solution of modifying their concession contracts. This paper proposes imitating market-
Bus transport oriented solutions from private franchise chains to increase the service quality offered by transport
Quality operators, solutions that include the threat of losing rents or quasi-rents to stop franchisee
Concessions opportunism. The study bases its arguments on the complementarities between different control
mechanisms and the similarities between franchise and concession contracts. Similarly, the paper
proposes linking the renewal of concession contracts to the administrative reputation of operators
(measured by customer feedback on service quality). The study also provides details on the
implementation of such an incentive system.
& 2010 Published by Elsevier Ltd.

1. Introduction them to implement profit-boosting policies that lower service

Agency theory and transaction costs economics have revealed
the significance of opportunism in economic problems over recent
decades (Jensen and Meckling, 1976; Williamson, 1985). One of
their main objectives has been to find a solution to ex post
opportunism (Fama and Jensen, 1983; Williamson, 1985, 1996),
normally called moral hazard. Many authors have studied what
safeguards should be built into contracts to deal with this
problem.1 Franchising or transport concessions should not be an
exception, as they are based on a detailed contract between the
franchisee/transport operator and the franchisor/transport
authority. Lafontaine and Slade (2001) argue that the most
common contractual practices in franchise chains specifically
tackle this problem by linking franchisee remuneration to outlet
profit, or more precisely to residual income. This solution aligns
the incentives for franchisors and franchisees, thus attenuating
the problem of moral hazard. In a similar way, transport operators
are remunerated with the business profits in concession contracts.
The economics and business literature, however, reveals that
‘high-powered’ incentives (remuneration linked to residual
income) can create additional difficulties.2 Although these
incentives can guarantee maximum effort and diligence from
firms exploiting the business (franchisees), they may also induce
n 4
Corresponding author.
E-mail address: mangeles@ccee.ucm.es (Á. Montoro-Sánchez).
1
See Laffont and Tirole (1993) and Milgrom and Roberts (1992) for a
summary.
2
‘High powered’ refers to any variation in the performance indicators that
entirely and directly affect the agent’s remuneration (Williamson, 1996: 103).
quality (e.g., by decreasing input quality, reducing local adver-
tisement expenditure, hiring unskilled workers, etc.). These
policies can increase franchisee remuneration in the short term,
but may reduce the profits of the business as a whole, particularly
in the long term (Rubin, 1978, Brickley and Dark, 1987).
As occurs with franchise contracts, the problems of opportu-
nism do not end with the selection of concessionaires.3 Transport
operators that win concessions may begin to act like franchisees
and be tempted to take advantage of their market power,
maximizing profit at the expense of service quality.4 Aggravating
factors are the public nature of the transport authority and the
difficult lines of communication between the receiver of the
service (the passenger) and the transport authority.
The literature on contracts suggests two potentially comple-
mentary solutions for the problems of quality and information
asymmetry.5 One solution is for the less informed party to invest
resources in monitoring and control in order to reduce the
information asymmetry and thus prevent the other party from
acting opportunistically. This could require administrative control
to ensure concessionaires fulfill their obligations (e.g., a service
3
In Spain this is done by competitive tender. This forces operators to reveal
some of their information advantage over the transport authority on costs and
services. See De Rus et al. (2003).
This is an international problem in the whole transport sector because of the
widespread use of both monopolies and political intervention (Schiefelbusch,
2005).
5
See Milgrom and Roberts (1992) and Brickely et al. (2003) for two general
surveys and González-Dı́az and Raynaud (2005) for an application of these ideas to
the specific problem of quality.

0967-070X/$ - see front matter & 2010 Published by Elsevier Ltd.

doi:10.1016/j.tranpol.2010.09.001
300 M. González-Dı́az, A. Montoro-Sanchez / Transport Policy 18 (2011) 299–306
quality index, as proposed by Hensher et al., 2003). The second
solution is based on introducing safeguards that reduce the
conflict of interests between parties, for example by designing an
incentive system that makes agents partially responsible for their
decisions. Agency theory stresses this last point because it is an
automatic mechanism that usually lowers the costs of super-
vision, and because it becomes the only economically viable
solution when the costs of monitoring agents’ behavior are high
(Holmström, 1979).
Lafontaine and Slade (2001) argue that franchisors introduce
such an incentive system when they reserve the right to
terminate contracts unilaterally and make strict compliance a
condition for contract continuity. In this way, a self-enforcing
system of incentives is set up (Klein, 1995): franchisees control
their behavior because they know they will lose their investment
and future earnings if they indulge in opportunistic behavior.
Lafontaine and Raynaud (2002) also argue that the coexistence
(complementariness) of the two mechanisms is what makes an
incentive system truly successful. While linking remuneration to
residual income lessens the chance of ex post opportunism, the
threat of contract termination – with the resulting loss of rents
and quasi-rents – will attenuate the harmful effects of this high-
powered incentive system.
Given this situation, it is surprising to see that the transport
authorities in Spain hardly ever introduce incentive systems in
service concession contracts for regular scheduled public trans-
port.6 Transport authorities control concessionaires solely via a
superficial system of inspection7—no self-enforcing incentive
system has yet been considered.
The aim of this paper is to show how an incentive system could
be introduced into the concessions of regular scheduled public
transport services to improve the quality of service for passengers.
This measure would also strengthen the control of opportunistic
best behavior. Specifically, we suggest imitating (benchmarking)
franchise contracts. In the same way that franchisors make
franchise contracts conditional on strict compliance with their
instructions and levels of customer satisfaction, concession
contracts would oblige transport operators to achieve good
administrative reputations to maintain their concessions. Admin-
istrative reputation would be based on the results of monitoring a
series of variables related to customer satisfaction and compli-
ance with the minimum requirements. The economic success of
the franchise model appears to support this recommendation, and
the recommendation is also consistent with the tendency to look
for alternatives to competitive tendering (e.g., negotiated perfor-
mance-based contracts) when contracting costs are high (e.g.,
with clear, incomplete contracts) (Hensher and Stanley, 2008).
Although our proposal contains significant conceptual differ-
ences, the idea of rewarding the best operators is not new. In
2003, the government of Catalonia introduced a scheme to offer
concession extensions to operators that were willing to undertake
suggested improvements. The aim of our proposal, however, is to
go beyond the simple Catalonian model of reducing or extending
contract duration and to present objective grounds for renewing
concessions. We focus on customer preferences to determine the
key factors to improve service quality. To achieve this better
quality, the ‘reward’ (contract renewal or extension) must be
based on the results of regular customer satisfaction surveys, and
6
We take the concession system as a given; it is not our goal here to enter the
open discussion on which competitive structure is best. See Cambini and Filippini
(2003), Demsetz (1968), Prileszky (2005) and Van de Velde (2003), among many
others.
7
Law 16/1987 on the Organization of Land Transport entrusts the ‘inspection
to guarantee fulfillment of the regulatory norms of land transport [y] to the land
transport inspection services’ (Article 32 and ff.).
not handed over in advance after passing a technical and financial
analysis of theoretical viability.8 International examples exist
(e.g., Norway and Australia) where incentive systems have been
introduced. These systems function differently, however, as the
government subsidizes operators in an attempt either to max-
imize customer satisfaction on a fixed budget or to cut the budget
as far as possible for a particular level of service.9
In the following section, we describe Spanish concession
contracts and show how they fail to protect quality sufficiently.
We then introduce and analyze franchise contracts via bench-
marking, examining the problem of how franchisees and
concessionaires disregard externalities. In Section 4, we describe
an incentive system that could be included in concession
contracts to solve this problem. The final section summarizes
our conclusions and recommendations.
2. Concession contracts in road passenger transport in Spain
The 1987 Organization of Land Transport law (LOTT, in its
Spanish acronym) gives regular scheduled public transport for
general use the status of a public service to be managed indirectly
by administrative concession. The transport authority grants an
operator exclusivity to convey passengers for a stipulated period
of time and route. These concessions are awarded by competitive
tender to the operator that makes the best offer in terms of
quality, price, etc. The operator is obliged to charge a fare
regulated by the transport authority, and to deliver the service in
compliance with the stipulated tender conditions and quality. The
operator must use its own assets and is responsible for expenses
and revenue. Consequently, once the concession has been
awarded, a legal monopoly to exploit the bus line exists, a
monopoly that completely closes the market for the duration of
the concession (Izquierdo-Llanes and Fernández-Sánchez, 2004).
Although the tender specifications set out the conditions the
operator must comply with, these conditions are not all equal. In
competitive tendering, distinctions exist between the following:
 essential conditions (obligatory, with no changes permitted:
routes, concession period);
 minimum conditions (obligatory, but which can be exceeded:
number and type of vehicles, number of services and seasonal
schedules) and
 guidance conditions (which can be freely modified: amortiza-
tion periods and service timetables).
Of these conditions, fares are crucial because this type of
transport is subject to obligatory maximums that are set in the
concession agreement as part of a controlled pricing system. Fares
are reviewed via a system that takes account of real inflation over
the previous 12 months, adjusted by a reduction indicator based
on each operator’s performance. These fares should cover the total
real costs under normal conditions of productivity and allow –
along with remunerating complementary services – acceptable
amortization, reasonable business profit, and satisfactory service
or performance of the activity (Fernández-Farreres, 2004).
The LOTT states that the duration of concessions cannot be
shorter than 8 years or longer than 20, and that the duration must
always be specified in the tender conditions. In general, the
standard concession period for national bus lines has been 12
8
Decree 128/2003 (13 May) on measures to innovate and improve quality in
the regular passenger transport services in Catalonia (DOGC no. 3893, 28 May
2003).
9
See Carlquist (2001) and Dalen and Gómez-Lobo (2003) for the Norwegian
case and Hensher and Houghton (2004) for the Australian example.
 M. González-Dı́az, A. Montoro-Sanchez / Transport Policy 18 (2011) 299–306
years, with the possibility of extending it a further 5 years for
those concession holders that promise to freeze fares for 2 years
(law of 13/1996). Most of these concessions, then, will end
between 2007 and 2013, from which time new concessions will
conform to the minimum of six and maximum of 15 years set out
in the royal decree-law of 4/2000 (23 June). Meanwhile, the
European Parliament and Council included a maximum limited
duration of 5 years in its proposal to regulate member states’ road
passenger transport questions.
We have surveyed a sample of concession titles that were
operative in Spain in 2005 to compare their variability, especially
among the different local government administrations. The most
outstanding feature is their great similarity. All the contracts
define in detail:
(a) subject (route, listing stops and distances);
(b) service conditions, including information on services and
seasonal schedules, registered vehicles and facilities;
(c) economic conditions (maximum fares and cost structures) and
(d) legal and administrative conditions, including information on
the duration of the concession, rights and obligations of
operators (guarantee bonds, direct control, transfers, aban-
donment, additional services, etc.), and the obligations of the
transport authority (modifications, terminations, inspections,
redemptions, penalties, etc.).
Some minor differences do exist among local government
authorities. These differences mainly relate to the complexity and
detail of fare structures and timetables (e.g., in Madrid, where the
outlying area is divided into several zones), and attempts to
improve the service quality (e.g., in Catalonia). The most
important finding for our work, however, is the complete absence
of explicit incentive systems. Among current concession con-
tracts, then, hardly a single incentive system exists to promote
service quality (the exception being the modest efforts made by
the local government of Catalonia in the law of 13/1996).
Quality in bus concessions is important, however, particularly at
the level of transport authorities (Hensher et al., 2003). Proof of this
is the action plan for bus passenger transport (PLATA, in its Spanish
acronym), one of whose objectives is to improve passengers’
perception of quality (Fundación CETMO, 2008). The Ministry of
Development (Ministerio de Fomento) itself notes that passengers’
perception of quality has fallen in recent years. In line with data
from the General Directorate of Road Transport’s (part of the
Ministry of Development’s General Transport Secretariat) two-yearly
survey,10 service quality perceived by passengers has fallen from
3.80 (out of 5) in 2000 till 3.54 in 2006 (Ministerio de Fomento,
2009: 75). The aspects that scored worst were customer service on
the bus, information about passengers’ rights, timetables, the
availability of complaint forms, and the safety and control of
luggage (p. 72). Apart from this official survey, no other studies
evaluate the quality of public road passenger transport in Spain.
In order to complement and strengthen the conclusions of the
Ministry of Development’s survey, we performed an exploratory
study gathering information from 29 news reports published in
10
The last analysis performed in 2006 collected information from a total of
20,691surveys in 30 stations—most in provincial capitals and in towns with fewer
than 25,000 inhabitants. The overall quality score is the result of measuring the
following 19 items related to service: safety during the journey; punctuality of
departure; staff friendliness and politeness; cleanliness of the bus; quality of the
vehicles; comfort of the bus; information and sale of tickets; punctuality of arrival;
interior temperature; information and signposting in departure station; connec-
tions with other lines; location of stops; value-for-money relation; maintenance
and cleanliness of stations; safety and control of luggage; availability of passenger
complaint forms; frequency of services; information on passengers’ rights; other
services (drinks, newspapers, headphones, etc.).
301
economics journals about road passengers’ complaints.11 Half of
these new reports were about: (1) infrequent services and
(2) non-compliance with timetables. In order of importance, the
other complaints were (3) poorly equipped stations (both in terms
of ease of use for the disabled and the passenger information
available) and (4) badly signposted and equipped bus shelters. To
a lesser extent, the reports also referred to complaints about
buses not being properly equipped for disabled people, poor
driving, long queues in stations (both to buy tickets and board
buses), ticket prices and transfer charges.
In summary, all of this illustrates that quality is important in
transport services. In fact, the concern of the General Directorate
of Road Transport has been evident for some years. Not only has
the Directorate been collecting information on perceived quality,
but it has also taken steps to improve levels of road passenger
satisfaction and public transport services (Fundación CETMO,
2006).
3. Franchise contracts: a reference model
3.1. Franchising and concession: How similar are they?
Franchise contracts have similar economic characteristics to
administrative concessions. Vaughn (1979: 12) states that a
franchise exists when ‘[y] a parent company gives an individual
or company the right, or privilege, to run a business in a pre-
established way during a determined length of time in a specific
place. The parent company is called the franchisor; the individual
or firm that receives the privilege is the franchisee; and the right
or privilege itself is the franchise.’ This definition stresses the
similarity with concession contracts, where the transport author-
ity plays the role of franchisor and the transport operator that of
franchisee. Both contracts, then, can be seen from an economic
standpoint as the legal instrument of an agency relationship
between the principal (franchisor or transport authority) and the
agent (franchisee or operator); the former owns (or has authority
over) a business concept and temporarily cedes it to the latter.
Consequently, franchise and concession contracts create
similar incentive systems.12 In both cases the exploitation of the
business is in the hands of an independent firm that is
remunerated with its profits (or residual income). On the one
hand, this form of remuneration provides sufficient incentive to
the agent (franchisee or operator) to work as hard as possible, as it
benefits directly from its efforts. (Employees – public or private –
do not have the same incentive as they are not totally responsible
for the economic consequences of their decisions.) While on the
other hand, this remuneration system resolves a problem of
adverse selection (Norton 1988, 1995). Completely variable
remuneration (profits or residual income) screens potential
franchisees (or operators), as those that are looking for an easy
ride will search for employment alternatives with fixed salaries.
Since the remuneration of franchisees (or operators) is completely
variable, they only make money if they put in maximum effort.13
11
Please note that these results merely provide an indication of the problem
of quality in bus transport. The limited number of cases and the sampling used
make it impossible to draw statistically significant conclusions.
12
Interpreting franchise contracts as agency relations, and therefore as
incentive systems to reduce moral hazard, is the most common practice in the
literature. See Caves and Murphy (1976), Rubin (1978), Mathewson and Winter
(1985), Lafontaine (1992) and as a summary of the state of the art, Blair and
Lafontaine (2005: 107–115).
13
This is the same self-selection argument that piece-work pay produces:
only employees who feel able and willing to work hard usually accept this type of
remuneration (Baker et al., 1988).
302 M. González-Dı́az, A. Montoro-Sanchez / Transport Policy 18 (2011) 299–306
In addition, franchisees must be confident of success, as many
times they have to go into debt to raise the start-up investment
for the business. Thus, only franchisees that have confidence in
their ability to succeed will be likely to take the chance.
Concession contracts for passenger transport should have a
similar effect, as operators will only be successful if they
are able to attract passengers. Here again, operators need to
have sufficient confidence to make the start-up investment
(purchase of vehicles, bonds, equipping of premises, etc.)
necessary to win the typical competitive tendering process
(De Rus et al., 2003).
Geographic exclusivity and price limits are two of the most
common clauses in franchise and concession contracts. Franchise
contracts usually include a commitment by the franchisor to
award exclusivity in a geographical area to the franchisee
(Hadfield, 1990). There are two reasons for this. First, this clause
reduces the temptation for franchisors to take advantage of their
position, by opening their own outlets in areas that franchisees
have found to be the most profitable. Moreover, the clause gives
franchisees an incentive to exploit their areas as thoroughly as
possible, as they will be the main losers of failing to do so. The
absence of direct competitors also allows them to maximize the
market power of a franchisor’s product and thus obtain similar
profitability to that of the franchisor for themselves (Blair and
Lafontaine, 2005: 202–235). As we argued in the previous section,
the situation is similar in transport concessions because the
operator has exclusivity over a specific regular scheduled public
transport line.
Second, price limits are present in both contracts. Geographic
exclusivity gives the franchisee market power, which can cause
successive monopolies to develop and consequent problems of
double marginalization. This situation causes decreased produc-
tion, price rises to the public, and lower profits in the chain as a
whole than would be obtained with a single vertically integrated
monopoly (Spengler, 1950). One of the most common solutions to
this problem is limiting the freedom of franchisees to set prices,
obliging them to set prices that maximize the whole chain’s profit
instead of that of their own outlets (Blair and Kaserman, 1983:
35–36). In this way, the customer also wins as production is
greater and the price is lower. Price limits in passenger transport
concessions may act in the same way, as the operator has a near
monopoly on its route (with the exception of alternative means of
transport like train, car or airplane).
The main incentive difference between concession and
franchise contracts,14 however, lies in the distinct nature of the
principal when they are considered as an agency relationship. In
franchise contracts the principal is a private firm acting in its own
name, while in concession contracts the principal is the transport
authority, acting on behalf of the citizens. In other words, in
concession contracts there is a double agency relationship: of the
citizens over the politicians, and of the politicians over the
concessionaire. Therefore, the ultimate principals are the passen-
gers themselves. In line with the arguments of Alchian and
Demsetz (1972), the economic significance of this difference is
that the most motivated controllers are those that receive the
residual income (i.e., the entrepreneur or private company), as
any control effort they perform has a direct impact on themselves.
The transport authority, however, does not benefit directly from
putting more effort into control, which makes it likely that its
incentive to make this effort is less than for a private firm.
14
Please note that we are considering ‘franchise contract’ from an economic
and general point of view. Lawyers may refer to bus service franchise contracts in a
slightly different way. See the appendix for a definition of both bus franchise and
concession contracts.
3.2. Franchising problems and solutions
Incentive systems in franchise contracts also suffer from
problems of their own. One of the most well known is the
tendency of franchisees to ignore the effect of each outlet’s
externalities on the whole chain, for example by reducing the
quality of the product (Rubin, 1978; Brickley and Dark, 1987).
Franchisees with a high percentage of irregular customers may
think that unilaterally lowering product quality will allow them
to reduce costs without significantly losing customers, whose
loyalty would be assured by the overall quality offered by the rest
of the chain. Problems arise with this reasoning when too many
franchisees begin to think – and act – in this way, thus dragging
down the average of the whole chain and potentially causing the
business to run into difficulties.
Since the incentives in franchise and concession contracts are
similar, the latter should also suffer from comparable problems of
quality. Once concessions have been obtained from the transport
authority, operators may decide their best course of action is to
reduce service quality. Theoretically, this problem of quality is
likely to be more serious in administrative concessions than in
private franchise contracts as in the former the principal is the
transport authority—and the transport authority is not as
motivated as a private company to monitor quality because it
derives no direct benefit (in terms of profit or residual income)
from it. Its interest derives from its role as user or its desire to
protect its political reputation. Moreover, information about
service shortcomings does not easily filter back to the transport
authority, unless the proper channels are created. Indeed,
compensation claims resulting from complaints are usually
lodged against the operator itself, with few reaching the
consumer protection or road passenger travel inspection services.
The importance of this problem, however, depends on the
demand characteristics. When passengers have little chance of
changing their method of transport (inelastic demand), operators
are likely to have a greater incentive to reduce quality (costs). And
the opposite is true when passengers have easily available
alternative methods of transport.
The problem of the conflicting ways in which franchisors and
franchisees view quality can be resolved in two manners. First, the
party that lacks information (franchisor) can invest resources in
obtaining the information. And second, an incentive system that
tries to reduce the conflict of interests between the parties can be
built into contracts.
3.2.1. Monitoring and control
One way of preventing opportunistic behavior is to get
franchisors to invest resources to stop it. To do this, the contract
should include a detailed specification of the production system,
materials and service to be delivered. These points can then be
checked at a later date to see that franchisees are complying with
the norms and instructions.15 This monitoring and control process
is usually expensive, especially if it is comprehensive. Although
the franchisor is liable for this, the costs actually fall on the
relationship and can therefore be passed on to the franchisee
through a negotiated settlement, higher royalty rates and/or up-
front fee.
The most common mechanisms used by franchisors are
field audits, mystery shoppers, surveys and information systems
(Bradach, 1997, 1998). In field audits, an employee of the
franchisor goes to the franchisee’s outlet to directly observe
the production system and/or service. Inspections typically focus
15
Specific details on how some chains perform these inspections can be found
in Love (1986), Dnes (1992) and Bradach (1998).
 M. González-Dı́az, A. Montoro-Sanchez / Transport Policy 18 (2011) 299–306
on the skills of employees, levels of service and the quality
of the inputs, among many others. Mystery shoppers are also
employees of the franchisor. These shoppers pose as customers
and visit the different outlets (of both the parent firm and the
franchisee) unannounced to grade the service that customers
receive. These undercover inspectors score factors like speed
of service, cleanliness, friendliness, information given, condition
of the outlet, etc. Real customers are also asked for their opinions
on a variety of key indicators of satisfaction. Lastly, franchisors
provide the information systems, thus giving them access to much
of the franchisee’s information (e.g., overall sales, top-selling
products, types of sale, etc.). In some cases, these systems also
supply information on inventory levels and the franchisee’s
expenses.
3.2.2. Incentive contracts
This approach requires all parties to work together on
designing a contract that aligns their interests on quality. This is
usually achieved by including an incentive system that makes
franchisees partly responsible for their actions, by negatively
linking payment (profit) to some measure of the externalities they
want to prevent (e.g., lower service quality) (Blair and Lafontaine,
2005: 117–138). Performance-related pay is more economical
than monitoring the behavior of agents, which usually turns out
to be expensive, especially when dealing with services or when
outlets are geographically spread out. In fact, franchising uses
inspections and direct supervision as a complement and support
to incentive systems, as they link the continuity of contracts and/
or access to new outlets to favorable inspection reports (Bradach,
1997; Blair and Lafontaine, 2005: 117–138).
This incentive mechanism is self-enforcing in that it gets
franchisees to act in their own interests. Since the franchisor has
the power to terminate contracts (and thus endanger the
investments (quasi-rents) of franchisees), the risk of being
discovered cheating far outweighs any potential benefits (Klein
and Leffler, 1981; Klein, 1995). Poorly performing franchisees
could even miss out on future business opportunities (rents) in
the franchisor’s new outlets.16 The fear of losing rents or quasi-
rents, therefore, is what stops opportunistic behavior, which in
turn becomes a complement to counterbalance the excessive
intensity of franchisees’ profit-related incentives.
4. Designing a concession contract
The central issue is how to transfer the lessons learned from
franchise contracts into the context of administrative concessions.
Since we argue that the economic nature of both contracts is
similar, we postulate that what works in one should work in the
other. We propose, therefore, to use our knowledge of franchise
contracts to design administrative concession contracts.
4.1. Administrative reputation
The first lesson that franchise contracts can teach us about
administrative concession contracts is that the latter should include
an incentive system that lessens the risk of ex post opportunism by
concessionaires. This system could be based on each concessio-
naire’s administrative reputation. Continuity of concession con-
tracts, then, would be at least partially determined by this
reputation. In other words, transport operators with the best track
16
The literature stresses that the system needs ‘rents’ to work (Lafontaine and
Raynaud, 2002).
303
records would be rewarded with contract renewals. Administrative
reputation would be calculated using the average scores obtained
via the transport authority’s evaluations (inspections and customer
satisfaction surveys) during the concession period. This approach
would imitate at an administrative level the private system of
incentives that links franchisors and franchisees (e.g., as in
McDonalds) and that has up to now produced good results for
franchise chains.17 Administrative reputation, then, motivates
operators to act impeccably during the concession period—just as
franchisees are motivated to act impeccably so that the franchisor
will reward them with better terms, contract renewals or further
outlets.
Administrative reputation would be built using a points
system. Points would be awarded to operators based on the
scores from each evaluation, with better scores resulting in more
points awarded. The points obtained would accumulate during
the concession period until the time for renewal, when an average
score for the whole period would be calculated. This score would
represent the operator’s administrative reputation (good or bad).
Based on these results, three groups could be set up.
Group 1 (low scores) would be for firms with ‘bad reputations’.
Operators in this group would automatically have their contracts
terminated, and could also have their ‘bad reputations’ count
against them in future competitive tendering processes.
Group 2 (satisfactory scores) would be for firms with ‘average
reputations’. Operators in this group would not automatically
have their contracts renewed, but would be well positioned in the
new tendering process.
Group 3 (high scores) would be for firms with ‘above average
reputations’. Operators in this group would be rewarded with
automatic contract renewals, limited to three concession periods.
After this time operators would be required to re-enter the
tendering process. This limit would keep the door on competition
open and would prevent too many concessions ending up in the
hands of too few operators.
Lastly, the transport authority would maintain the right to
terminate contracts of operators that failed to meet certain
minimum requirements.
4.2. Monitoring and evaluation
A single monitoring service should be set up to standardize the
scoring criteria as far as possible for all routes; in cases where
more than one monitoring service exists, they must be perfectly
coordinated. The quality assessed should be demand-oriented
instead of supply-oriented, because the latter underestimates
many passenger-related problems (Rietveld, 2005). Thus, passen-
gers’ perceptions of disturbances (delays, reduced availability of
seats, etc.) are the focus, perceptions that should be monitored via
fieldwork, surveys of users of transport services, surprise inspec-
tions and mystery users.18
To gauge passengers’ perceptions of service quality, at the very
least first-hand information on the following variables should be
collected and scored:
 Quality of service outside the vehicle:
J Safety of baggage.
J Friendliness and diligence dealing with incidents and
problems (availability of forms and trained staff).
17
Up-to-date data on the importance of franchising in Spain can be found at
/http://www.tormo.com/santander/franquiciados/informacion/datos/introduc
cion.aspS.
18
UNE regulation 13816 on quality of service from the users’ viewpoint is a
useful tool in this respect.
304 M. González-Dı́az, A. Montoro-Sanchez / Transport Policy 18 (2011) 299–306
J Ease of ticket purchase (availability of ticket counters, ticket
machines and on-line purchase) and friendliness at the
point of sales.
J Satisfactory facilities in stations, stops and shelters.
J Information on schedules, itineraries, route changes, etc.
 Quality of vehicle:
J Driver friendliness, appearance and level of training.
J Exterior cleanliness and condition of vehicle.
J Safety and smoothness of driving.
J Information updates during trip.
J Interior cleanliness and condition of vehicle.
J Quality of on-board services (audio, video, food and drinks,
newspapers and toilet facilities).
J Passive safety and vehicle comfort (leg-room, curtains, tinted
windows, tables, reclining seats and temperature control).
 Fares and schedules:
J Timetables, number of services and seats.
J Ease of connection with other lines.
J Punctuality of departures and arrivals.
J Duration of service (appropriate number and duration of
stops).
J Reasonable prices, range of fares and customer loyalty.
Apart from passengers’ opinions, the transport authority may
need to monitor other aspects that it considers fundamental to
develop the sector (e.g., issues such as raising environmental and
passive security standards).19 In these cases, the transport
authority may find it more economical to monitor the behavior
of operators directly. The typical passenger probably suffers from
an almost total lack of information that would be expensive to
resolve individually. Thus, making this type of control the
responsibility of one transport authority specialist appears to be
a good solution; one specialist could do what it would take the
efforts of hundreds of passengers to achieve.
The monitoring and control that we describe in this paper,
though, is not sufficient on its own to correct the problems of
opportunism. Inspectors and evaluators are able to deal directly with
aspects linked to the lack of information. Problems, however, usually
come from other not so easily observed aspects, where control is not
particularly effective, like for example the efforts of operators to get
staff to be friendly, punctual, neat and clean. Our only goal here,
therefore, is to look for estimators of these variables, estimators on
which the system of incentives can be built. Since the act of
collecting information is not dissimilar to that of monitoring and
control, the best solution appears to be to give the job of evaluating
the incentive system to the inspectors as well.
The transport authority must invest the necessary resources to
perform this task of evaluation. This is the basis of the incentive
system, a system that can only be successful if operators see it as
reliable. Currently in Spain these responsibilities are delegated to
local governments, which would make it necessary to negotiate
an agreement with them. Communication and negotiation
channels of this kind among many actors are called ‘policy
networks’. Using such policy networks does not necessarily result
in a loss of efficiency in the decision-making process because they
can help to achieve efficient horizontal relationships among
different political partners.20
19
Apart from these two aspects, the action plan for bus passenger transport
2003–2007 (PLATA, in its Spanish acronym) includes other useful measures more
directed towards developing the sector in the long term.
20
A discussion of the pros and cons of policy networks can be found in
Kennedy et al. (2005: 399–400).
4.3. Contract duration
One requirement that seems to be necessary for the system to
work correctly is shortening the duration of contracts to a period
that will keep the operators interested in enhancing their reputa-
tions. This safeguarding mechanism works when ‘repeated game’
conditions are present (Kreps and Wilson, 1982; Kreps et al., 1982).
Under these conditions, players are continuously interacting,
thereby making it possible to verify the strategies adopted by other
parties. With current contracts typically lasting more than 15 years,
the number of interactions is greatly reduced, which in turn reduces
the interest of the parties in enhancing their reputations.
Franchise contracts can once again serve as an example. The
average length of franchise contracts with a predetermined
duration in Spain is slightly more than 6 years, and the most
frequent (mode) length is 5 years. Furthermore, the trend is
towards reducing the duration of the longer contracts (20 years)
to shorter periods (5–10 years). Consequently, we propose that
the standard length of concession contracts should be 5 years, a
change that the European Union (EU) is planning to introduce.21
Our proposal also includes the options of terminating contracts
because of non-compliance or extending contracts because of
excellent service levels.
When contract renewal is linked to results – as in franchising –
the duration of the contract becomes less important. Firms
interested in enhancing their reputations and making long-term
commitments to the business spend more time concentrating on
how to obtain the required results and less time worrying about
securing the safety net of a long-term contract. Moreover, in the
transport sector arguments based on the specificity of the
investments do not appear to support such long-term contracts.22
Transport operators employ mobile and general use assets, which
significantly lowers their specificity as they can be re-used at low
cost for other activities (e.g., by another regular or chartered
transport company, including inter-city). Even when franchisees
make large specific investments, contract duration does not tend
to be a problem as contract renewal is practically guaranteed if
the franchisor’s guidelines are adhered to. In order to reduce the
chance of opportunism, then, operators should feel that poor
performance will put them at risk of having their contracts
terminated (i.e., they will lose quasi-rents).
4.4. Discussion of contract efficiency
This incentive system would keep the future behavior of
transport operators in line – as occurs in franchise contracts – for
two main reasons:
(a) Risk of losing investment (quasi-rents): If contracts are cancelled
early, operators will lose their investments. And it follows that
operators should also be interested in renewing contracts, as
this is the best way to turn a profit on past investments.
Although these investments (vehicles and human capital) are
not likely to be highly specific, loss of the contract will always
prove expensive for operators in terms of tying up assets,
searching for alternatives, re-painting vehicles and signs, etc.
(b) Access to new business (rents): Operators are interested in
keeping and enhancing their reputations if this helps them
enter other competitive tendering processes. This is a door to
new opportunities that it would be unwise to close, except
21
This is only a proposal at present as the regulation is still awaiting approval
(De Rus, 2000: 256).
22
This is the classic argument to justify extremely long-term contracts. See
Joskow (1987).
 M. González-Dı́az, A. Montoro-Sanchez / Transport Policy 18 (2011) 299–306
in situations where operators are considering withdrawing
from the business.
Introducing more explicit and stronger incentives (e.g., as
automobile manufacturers do with distributors)23 does not, how-
ever, seem advisable. It is no easy task for the transport authority to
put these measures into practice. Once operators obtain the
concession, the transport authority is no longer the supplier and
receives no payment from operators for the concession. In addition,
no agreed upon explicit and objective indicator of operator
performance exists, a factor which leaves evaluations open
to debate. As a result of the difficulty of measuring performance
(i.e., non-contractible variable), the literature on incentives usually
recommends subjective and less rigorous evaluations (Milgrom and
Roberts, 1992: 206–247). Our proposal to make contract renewals
dependent on repeated quality evaluations is in line with this
recommendation. A penalty system, however, could be set up for
the most obvious and common infractions.
Two critical conditions must be met for this proposal to work
correctly:
(a) Monitoring and evaluation system: The incentive system is
entirely based on monitoring and administratively grading
operators. Therefore, the transport authority needs to develop
and protect the evaluation procedure to ensure it is as reliable
as possible (Gómez-Ibáñez and Meyer, 1997). Failure to do
this will result in the collapse of the incentive system.
Transport authority employees themselves, however, should
not be charged with this task alone. Monitoring companies
could also be brought in and given sufficient independence
and control to do the job.
(b) Business opportunities or rents: The second prerequisite is that
operators should be motivated to continue with the conces-
sion. The return on the business, then, should make both
maintaining and taking on new concessions attractive
propositions. Operators, therefore, must not see their profits
strangled. The literature on this point stresses that profits
must be greater than the minimum necessary to attract
investment (i.e., rents). Operators that obtain a ‘reasonable’
return (above the cost of capital, taking the risk premium into
account), however, are still likely to maintain and look to
expand their interest in the business.
Lastly, we must remember that direct supervision and incentive
systems are, at least in this case, complementary—one is not a
substitute for the other. Consequently, the relationship between the
two must be looked after. Better and more reliable supervision will
result in stronger incentive systems. In other words, one must be
sure that the evaluation system is reliable before proceeding to
penalize an operator with contract termination.
5. Conclusions
This paper’s goal has been to examine how to improve the
current system of administrative concessions for regular sched-
uled public transport services—a system that seems to be
promoted by the regulator, both in Spain and the rest of Europe.
Current concession contracts do not include incentive systems to
promote high quality service (an issue of great importance to
23
Automobile manufacturers offer their distributors incentives by granting
them discounts on large orders if they reach their goals. These discounts are
usually agreed beforehand and are linked to the achievement of goals. They are an
important incentive for distributors to significantly reduce (up to 3.5%) the cost of
their raw materials (vehicles). See Arruñada et al. (2001).
305
passengers), but we recommend the inclusion of such incentives
in future contracts as the best way to boost the performance of
transport operators. Incorporating an incentive system into
contracts would add value by reducing the chances that operators
will act opportunistically ex post, especially regarding the quality
of service delivered. The formula recommended is based on that
used in franchising, and the popularity of the franchising model in
recent decades is testimony to its effectiveness. This formula
rewards the operators that deliver the best service – estimated via
inspections and passenger feedback – with contract renewals and
offers of new concessions. We also recommend making the threat
of contract termination for the worst operators a more credible
one, because the risk of losing investment (quasi-rents) is another
incentive for firms to improve performance.
This new system would make the duration of concession
periods less significant, while also making operators concentrate
on obtaining the good administrative reputation necessary for
contract renewal. Logically, then, the formal length of contracts
should be shortened to 5 years, as this would increase the
frequency of renewals and thus evaluations. This shortened
concession period would promote the need to enhance adminis-
trative reputation and make the proposed incentive system more
effective. Beyond this, the transport authority should develop a
monitoring system that provides information on passengers’
opinions about prices, schedules, and service inside and outside
the vehicle. This information is crucial to measure the adminis-
trative reputation of the different operators, information that
would be used to decide contract renewals (automatic in cases of
high performance) and non-renewals (in cases of sub-standard
performance). Moreover, the transport authority could reserve the
right to terminate contracts with immediate effect in cases where
the service inspections revealed serious infractions. Lastly, the
maximum number of automatic renewals should be limited to
three in order to keep the market open to competition. The
administrative reputations of operators in one context, however,
could be taken into account in other competitive tenders for
regular road passenger transport concessions.
Two critical conditions need to be met for this system to work
correctly. First, an effective monitoring and control system must
be developed—the entire incentive system is based on this. The
transport authority should, then, invest the necessary resources to
ensure that it works correctly. This does not mean, however, that
the transport authority itself has to perform the task with its own
employees; it could outsource the job to monitoring companies
with sufficient independence and control.
Second, operators must be sufficiently motivated to maintain
concessions. Therefore, a reasonable level of profits – one which
makes both staying in the business and looking for new
concessions attractive – needs to be guaranteed. And, we should
remember that in this case at least the direct monitoring and
incentive systems are complementary: a good and reliable
monitoring system will enhance the effectiveness of the incentive
system.
Although this proposal is based on private ordering, it is line
with those that see the need for alternatives to the ineffective
solution of competitive tendering in contexts where contracts are
complex and generate high contracting costs (Hensher and
Stanley, 2008). Promoting the inclusion of service quality in
contracts is clearly one of these contexts, and franchise contracts
provide an example of how it can be done.
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