User:RegEconomist/Public utility regulation (Transactions costs approach)

Public utility regulation is a government-imposed mechanism for controlling the terms and conditions at which certain services of a public utility are provided to its customers. Most public utilities are natural monopolies, so that there are no alternative suppliers providing close substitute services. The transactions cost economics (TCE) approach to public utility regulation identifies, as the central issue, the need for customers to make a sunk or irreversible investment to extract the most value from the public utility service. However, both sides recognise that, in this context, there is a need to manage the threat of "hold up" - the risk that the service provider will raise its prices ex post to extract the buyer's surplus. This threat is managed through governance arrangements. In some cases - e.g., where there are few, easily-identified buyers or where the interests of buyers can be effectively represented in a single entity - this threat can be managed through long-term contracts or vertical integration. However, where buyers are numerous, small, and/or not all able to negotiate at the outset, some additional mechanism is required. This could take the form of government provision of the service (a form of vertical integration) or government contracting for the service, as in public-private partnerships for the provision of services.

According to this view, public utility regulation should be viewed as a government-imposed long-term contract designed to protect and promote sunk investment by both the buyers and the service provider. It has many similarities to its closest relative: long-term government contracts such as concessions, franchises, or public-private partnership agreements, and some similarities to a somewhat more distant cousin: private long-term arrangements. Public utility regulation differs from both in that it is imposed by decree rather than voluntarily entered into. However, that basic objective of all of these mechanisms is the same: the protection and promotion of sunk investment by the service provider and the buyers. According to this approach, public utility regulation should be designed and carried out in such a way as to replicate the long-term arrangement that the parties would have written if they could have costlessly negotiated before either made any sunk investment.

The Theory

Transactions cost economics (TCE) focuses, amongst other things, on the implications of sunk (or, more precisely, relationship-specific) investments and uncertainty for economic transactions. The issues arising from the need for sunk investments are somewhat different depending on the number of service providers.

Transactions cost economics

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Alternative governance mechanisms when there are multiple service providers

This section describes conventional results in transactions cost economics (or the "economics of governance") which typically deals with the case where there are multiple potential service providers. In this case, even if the buyer needs to make a sunk investment to extract the most value from the service, in many cases the sunk investment will typically not be specific to any one service provider. In this case there is no need for special governance arrangements and a spot market transaction will suffice.

On the other hand, if the sunk investment of the buyer is specific to a particular service provider, the investment becomes relationship-specific. These specific investments might take the form of specialized physical assets, specialized human assets, or location-specific assets (amongst others). This gives rise to the problem that Williamson has called the Fundamental Transformation - even if there any many potential transacting partners ex ante, once the relationship-specific investment has been made, the value of that investment is tied to the continuation of a particular relationship (also known as a situation of bilateral dependency). In this context there arises the threat of ex post opportunism or hold-up. For example, if the buyer incurs the cost of the investment, the service provider might threaten to raise its charges ex post, expropriating the value the buyer receives from the transaction. In such cases there is economic value in on-going mechanisms governing the relationship between the service provider and the customer. "Value-preserving governance structures - to infuse order, thereby to mitigate conflict and to realize mutual gain - are sought".

In the case where there are competing service providers and an on-going supply of new customers, relatively simple mechanisms might suffice. For example, the service provider may promise to not discriminate between new customers and existing customers or service providers may compete to subsidise the sunk investments of buyers. As long as there is on-going competition for new customers, these mechanisms may be sufficient to protect the value of the investment of existing customers. If the life of the sunk investment is short enough, the desire to create and maintain a reputation for not exploiting customers may also act to discipline the service provider.

Where such mechanisms are not feasible, transactions cost economics points to two alternative governance mechanisms which may overcome the hold-up problem. One such mechanism is vertical integration. This approach, where it is feasible, allows for efficient resolution of disputes between the two parties, and may result in some other economies of integration, but has its own limits (see Theories of the Firm). Specifically, carrying out certain transactions within a single firm changes both incentive incentive intensity and the need for administrative controls which limits the efficient scope of the firm.

Finally, the hold-up problem may be overcome through a long-term contract (a form of vertical agreement) which protects the interests of both parties. Long-term contracts, however, involve certain trade-offs. The longer the contract the greater the number of potential future contingencies the contract needs to take into account. As a result, all complex contracts are unavoidably incomplete. "Parties will be confronted with the need to adapt to unanticipated disturbances that arise by reason of gaps, errors and omissions in the original contract". The design of a long-term contract requires balancing the need for prescription, in order to protect the sunk investments made by both parties, with the need for flexibility to respond to disturbances ex post. In practice, long-term contracts involve both a framework of rules, combined with a degree of discretion to allow adjustment to developments ex post, mechanisms for information disclosure and verification, and a mechanism for resolving disputes. Long-term contracts should be thought of as a constitution governing a relationship. The greater the uncertainty in the future the greater the flexibility required in the long-term contract and therefore the greater the potential for ex post opportunism. Nevertheless, where there is material economic value in the relationship it may be preferable to enter into a flexible long-term arrangement which at least offers some protection for sunk investments, rather than to not enter into any relationship at all.

Relationship-specific investments and governance arrangements with a single service provider

The situation is somewhat more complicated when there is just a single potential service provider. This might arise, for example, where there are economies of scale so that the service provider is a natural monopoly. Economies of scale are particularly important in network industries such as telecommunications, electricity transmission and distribution, railways, roads, postal services and so on.

Again, the key issue is the need for relationship-specific investment. However, when there is just a single service provider relationship-specific investment problems are likely to be more significant. Unlike the case above where there were multiple service providers, where there is just a single service provider it is likely that any sunk investment made by the buyer will be specific to the relationship with that service provider. Where no relationship-specific investment is required, this approach to regulation argues that no particular governance arrangements (and no particular regulation) is required. A possible example is a major amusement park for which there are substantial economies of scale, but no particular need for regulation.

[[Image:Alternative governance arrangements with a single service provider.jpg|thumb|upright=2.0|Alternative governance mechanisms when there is a single potential service providers

External links

• example.com