Chapter 13: Franchise Bidding and Cable Television

This unit investigates franchise bidding as an alternative to regulation for the case of natural monopoly.

If a natural monopoly is unregulated, we would expect that monopoly pricing would result.

If monopoly pricing persists, it can induce entry by one or more firms. The result can be an economically inefficient market structure (fail to produce market Q at minimum cost, since under natural monopoly the economically efficient solution only results when one firm serves the entire market).

Thus the usual prescription: accommodation of a monopoly structure (and perhaps even imposition of entry restrictions) and price regulation-classic public utilities situation….

Demsetz (JLE '68): Franchise bidding offers an alternative to the usual regulatory treatment of natural monopoly. The relevant government authority would auction the right to be the natural monopoly. Firms would bid with the price they would charge once they are the natural monopolist.

Presumably competitive bidding would lead to P = AC solution, AND if firms have different AC curves, the winner will be the firm with the lowest AC curve, further enhancing efficiency.

In fact, if one firm has a cost advantage relative to the others, then price would end up being slightly below the AC of the next-to-lowest-cost firm, and thus we would expect that the winning bidder would be able to price above its own AC.

Thus the role of government in this alternative situation is that of auctioneer rather than regulator.

Analysis of Franchise Bidding

Government-as-auctioneer as opposed to Government-as-regulator: Under competitive franchise bidding the government does not need to acquire (costly) information on the natural monopolists' cost structure.

Avoidance of A-J Effects: Since price is not set to recover expenses plus a rate of return on allowed rate base, there is no possibility of overcapitalization to strategically manipulate the rate base.

Thus in this simple scenario franchise bidding can replicate (or out-perform) regulation at a lower cost to the public.

But… Franchise bidding may not result in efficient resource allocation because P = AC > MC. To allow for two-part tariff bidding in the auction the government must also know market demand so as to determine which two-part tariff maximizes consumer surplus.

Compare bidding on ex-post price to bidding an ex-ante fixed fee for the right to be the natural monopolist: How are the ex-post market outcomes different, and under which scenario are consumers better off?

Quality: If product or service quality can vary, then franchise bidding schemes would have to also include product or service performance standards, or else have multidimensional bidding (firms bid price AND quality characteristics). Otherwise the winner may lower cost by lowering quality ex-post. Problem: What price-quality tradeoff is most preferred by consumers-ie, do consumers want Volvo-quality at a premium price, or will they settle for Ford Escort-quality if it is cheaper? How easy is it for regulators to monitor and enforce quality ex-post? Problem of objective quantification and an effective ex-ante penalty structure. Starting to look complicated….

Rent Seeking Activity

In this complex bidding environment in which the government auctioneer is unlikely to know consumers' preferred price-quality tradeoff, there are opportunities for the agency conducting the auction to inject its own preferences into the process. For example, local government auctioning off cable TV rights might be swayed by a bidder that offers to invest in public-use infrastructure such as videotaping equipment and other infrastructure. Even worse, government might auction the natural monopoly for an up-front fee (allowing the firm to charge monopoly prices ex-post), and then cut taxes and pander to the electorate.

Thus the firms would have an incentive to cater to the preferences of the government officials running the auction, with the objective being to win with a bid that trades off what the government officials want (fees, public services, bribes) in return for what the firm wants (ex-post rents-positive economic profit).

Thus the process is called rent-seeking. In this case "rent" refers to above-normal ex-post profit, and "rent-seeking behavior" includes offering fees to government, performing public service, or even bribes or contributions to election campaigns.

The Temporal Element

So far we have assumed once-and-for-all bidding. But what if the economic environment is subject to changes in unforeseeable ways? New technology, changes in demand, changes in input costs. It may be known in the ex-ante bidding stage that ex-post renegotiation will be required by one or both parties.

If this is the only problem, then the solution is to have recurrent short-term contracts. Thus when conditions change the natural monopoly position can be put up to bid again, allowing for adjustment of terms to reflect changes in the economic environment.

One clear problem with recurrent short-term contracts occurs when the winning firm is required to make sunk-cost investment in plant and equipment (e.g., stringing cable to residences), and the useable life of this sunk-cost investment exceeds the time period of the short-term contract. In this case outside bidders would have to include a buy-out payment for this sunk-cost investment in its bid. But who decides how much the sunk-cost investment is worth?

Another problem is failure of bidding parity. For example, the incumbent natural monopolist has already made a fixed-cost investment in plant and equipment, and so can win by bidding below the ATC of an outside firm, even if the outside firm's ATC curve is lower than that of the incumbent firm. Solution: buyout of physical capital. But at what price?

Finally, risk-averse regulators may want to maintain the status-quo, even if there is the potential for cost savings from changing the identify of the natural monopolist. Plus, its extra work.

In the context of uncertain future cost and demand, the main alternative to recurrent short-term contracting is long-term incomplete contracting with periodic renegotiation of terms. Why incomplete? Because it is effectively impossible to write a complete contingent claims contract that is mutually satisfactory to all parties in all possible states of nature.

A problem with incomplete contracting is ex-post opportunistic behavior. For example, the winning firm might strategically underbid to win, and then later petition for a price increase, claiming that they overestimated demand or underestimated cost. If there is a cost to re-opening bidding, then the firm can succeed. The government may also be opportunistic, exploiting the firm once it has sunk transaction-specific assets. Reputations can support efficient incomplete contracting…. See Hackett research papers….

Thus in real-world contexts, franchise bidding begins to look more and more like regulation.

Cable TV

With few exceptions (DirecTV, local "free" broadcasts, a few double-cabled communities), most of the 10,000+ cable systems in the US are local franchise monopolies.

Communications Act of 1934: FCC created, given power to regulate wire, TV, and radio broadcasts.

FCC refused to accept regulatory jurisdiction over cable TV in the '50s, claiming cable TV was neither a broadcasting facility nor a wire common carrier (huh?).

"Free" broadcasters pressured the FCC to regulate cable TV when cable TV started bringing in imported channels that undercut free broadcast market shares and thus ad revenues. 1962: FCC disallowed cable TV firms from importing distant-signal broadcasts when the same broadcast was available locally. 1966: FCC asserted full regulatory authority over cable TV. Required cable TV to carry all local TV stations and prohibited importation of ANY additional signals in top-100 TV markets. Somewhat relaxed in 1972. '65-'75: subscribers increased from 1.2 to 8.5 million. 1975: first TV satellite launched; no longer strictly reliant on microwave. Court: HBO decision allowed cable TV to compete against "free" broadcast TV, resulting in a big boost in number of imported programs and thus the number of active channels.

Cable TV is an available option for more than 96 percent of the population in the US, and as of 1993 there were nearly 60 million subscribers.

Cable TV is a high fixed (and sunk) cost industry, with most of the cost tied up in cabled signal distribution. The higher the market penetration (percent of those with access to subscribe), presumably the lower is AC. This is called economy of density, as it suggests that a single firm should serve a given geographical area. Webb, Noam, and Owen/Greenhalgh all separately found support for economies of density in cable TV. Thus there are considerable economies to not having cable systems overlap. Thus there exists a rationale for either regulation or franchise bidding of cable TV.

The most common contract used by local government is a long-term nonexclusive contract, typically 15 years in duration; nonexclusivity allows the government to re-auction the franchise if the current franchisee fails to perform in a satisfactory manner. Generally, franchise bidding involves 4 or 5 firms. Since (as of 1990) the largest 5 firms controlled around ½ of the US market, there is considerable potential for collusion and (local) market division. Local governments usually demand payment of a fixed fee or a percentage of revenues (up to a FCC-established 5 percent max.). Bidders respond to the FCC limit by offering non-price concessions such as channels for public service, educational use, and government use, parks, studios, etc. Every dollar spent on non-price concessions was found to raise monthly subscriber fees by 35 cents.

Dimensions of competition:

• Price of cable service. Research suggests that additional competitors during the ex-ante bidding process results in lower prices.
• Product quality, including channel capacity, signal quality and reliability.
• Nonprice concessions. Interestingly, Beutel found that chances of winning are higher when prices are higher-local government gets a fixed fee or a revenue share that is a hidden and thus politically more acceptable tax. Nonprice concessions result in uneconomic investments of between $5 and $6 per subscriber per month.

Performance After Initial Award

Reputations matter. Firms that operate in multiple areas (and thus may want to succeed in winning a franchise in the future) were less likely to have construction delays. Most all franchises are renewed (over 99 percent).

Price: In 1987 the FCC deregulated all but 3 percent of cable systems in the US. Following deregulation the price of cable TV rose faster than inflation, though the number of channels has also risen. Rubinovitz concluded that inflation and quality-adjusted cable TV rates were higher by around 20 percent, attributable to market power. In 1992 the US Congress reinstated price regulation on cable TV, either by the franchising authority or by the FCC. Unfortunately cable TV firms could avoid some rate regulation by shifting more channels to unregulated or a la carte status, and these loopholes are difficult to fix.

Interestingly, despite the evidence that cable TV is a natural monopoly, in those communities where there are multiple cable TV firms (and thus consumers can pick from 2 or more firms), rates are significantly lower than when there was only one firm and its rates were regulated. Thus regulation is less effective at constraining monopoly pricing than is competition, even in a natural monopoly context.

Since 1996 cable TV is deregulated once again, though the FCC can intervene. The hope was for additional competition from new technology. Right.