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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.
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
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
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
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:
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.
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 nontowage 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 ) ≥
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.
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
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
when s = 0 and increases at rate 2F ′F ′′ which exceeds F ′ so long as F ′′ exceeds one-half. By 5 assumption, F ′′ ≥ 9 . 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 + FQs ) 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 pricing and service levels are found by setting s and z to maximise subject to F ( s ) = ( a + s − z )( z − c − θ ) . The first order conditions are:
(a + s − z)
a + s − z + λ ( z − c − θ ) − λ F ′( s ) = 0
−( a + s − z ) − λ ( z − c − θ ) + λ ( a + s − z ) = 0
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*
F where a − c − θ = F ′( s* ) + F ′((ss*)) − s* .
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 =
( 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. The integrated port profit is given by π I = (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).
( a + sI − c − θ )
− F ( sI ) .
PROOF: The two service levels are implicitly defined by F * a − c − θ = 2 F ′( sI ) − sI and a − c − θ = F ′( s* ) + F ′((ss*)) − s* . The left hand sides of
these equations are equal and, as noted above, F ( s) < F ′( s ) 2 . Thus
F a − c − θ = F ′( s* ) + F ′((ss*)) − s* < 2 F ′( s* ) − s* . Noting that F ′′ > 0 , this means that
sI must be strictly less than s* .
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 = 1 ( a + s + 2c − θ ) and r = 1 ( a + s + 2θ − c ) . The total 3 3 price for port services is given by r + p = 1 ( 2a + 2 s + c + θ ) . It is easy to confirm that 3 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 = 1 ( a + s − c − θ ) − F ( s ) and π A = 9
(a + s − c −θ )
. 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 service level sA such that π T is just driven to zero or
( a + sA − c − θ )
− 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 = 9 F ′( sT ) − sT . It is clear that this level of service is below the level that 2
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 spillover 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 = 9 F ′( sC ) − sC . Note that this level 4 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
(a + s − c − θ ) 2 − F ( s ) .14 The
optimal unregulated service level is implicitly defined by a − c − θ = 9 F ′ ( sU ) − sU . 5 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.
Given our assumptions on
F ′′( s ) , this is a concave function in s.
Figure 1: Equilibrium Service Levels
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.
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 + FQs ) . 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,
( 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 contestable contract will set s and zT to maximise
( a + s − zT − θ )
( 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, F * F * a − c − θ = F ′( s* ) + F ′((ss*)) − s* < 2 F ′( s* ) + F ′((ss*)) − s* so that the fully contestable service level is below the constrained socially optimal service level. Similarly, F a − c − θ = 2 F ′( sI ) − sI < 2 F ′( sI ) + F ′((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 =
( a + s − zT + θ ) . Thus, the quantity of
towage purchased given service level s is given by Q = is given by π A =
( a + s − zT − θ ) . Profit for A
( a + s − zT − θ )
. A will set the level of service to maximise its
profit subject to the zero profit constraint for T,
( 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 sidepayments.
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.
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. 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.
PROOF: Recall that
(a + s − c − θ )2 − F ( s )
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
(a − c −θ )
with social welfare under delegated tendering
equal to ( a − c − θ ) . In contrast, sU equals
(a − c −θ )
with social surplus equal to
(a − c −θ )
. 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.
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.
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