Contestable Licensing

We analyze a model of (repeated) franchise bidding for natural monopoly that relies on contestable licensing -- the right to operate the franchise belongs to the party who owns the appropriate license as long as the license is not successfully contested through a process of competitive bidding -- and demonstrate the usefulness of contestable licensing in inducing high quality performance from incumbent franchisees. In a world where quality is observable but not verifiable, the simple regulatory scheme we describe combines market-like incentives with regulatory oversight to generate efficient outcomes. Our analysis builds on the "Chicago approach" to regulating a natural monopoly (Demsetz (1968), Stigler (1968), and Posner (1972)). We consider a natural monopoly franchise. Every period, the incumbent monopolist (franchisee) may either provide high quality service which yields a "normal" rent, or low quality service, which results in a correspondingly higher per-period payoff for the monopolist, but lower overall welfare. The quality of service is observable by the relevant regulatory agency, but it is not verifiable in court. Because of this non-verifiability, the political economy environment in which the regulator operates makes it difficult for the regulator to credibly commit to transfer the franchise to another firm upon observation of low quality. The scheme we describe facilitates such commitment, and provides the appropriate "checks and balances" to ensure that it is not abused by an opportunistic regulator. The analysis gives rise to a number of interesting conclusions. Perhaps the most important of which is that the formal separation in the model between the issue of the quality of service on the one hand, and the price and cost of operation on the other hand, allows us to describe a regulatory scheme that permits the combination of assuring high quality service together with the provision of "high-powered" incentives for cost reduction.