Public Contracting : The Franchise Bidding Solution

Franchise bidding has been proposed as an alternative to regulation in contexts where natural monopolies arise—such as water supply, highways, and hospitals—by introducing competition for the market rather than in the market. The mechanism relies on competitive tenders to allocate long-term public contracts to private firms, aiming to mimic market pricing and avoid direct regulatory oversight. While this model promises efficiency and reduced public oversight, it encounters significant challenges at each phase of implementation due to transaction costs.

First, at the selection stage, governments must navigate complex procurement processes involving multiple criteria (e.g., price and quality), risks of collusion or corruption, and the problem of ""winner’s curse,"" where the most optimistic bidder wins but is likely to fail. These dynamics can result in inefficient or unstable partnerships. Solutions like the Least Present Value of Revenue (LPVR) model—where firms bid on revenue thresholds rather than fixed prices—can mitigate such risks and have shown success in practice, notably in Chile.

Second, during the enforcement stage, long-term contracts are typically incomplete and prone to renegotiation. Governments cannot fully specify or verify all terms ex ante, especially regarding future investments or demand changes. This results in underinvestment and frequent contract modifications, as illustrated by empirical evidence across sectors and countries showing high renegotiation rates.

Third, at the renewal stage, the initially selected provider gains an advantage due to asset specificity and accumulated knowledge—what Oliver Williamson terms the ""fundamental transformation."" This erodes the feasibility of reintroducing genuine competition, as switching costs become prohibitive. Empirical studies show that incumbents often retain their contracts, especially in smaller municipalities with limited capacity to retender.

Altogether, while franchise bidding offers a theoretical escape from regulatory inefficiencies, it is itself subject to strategic behavior, asymmetrical information, and renegotiation dynamics. These transaction costs undermine its promise of frictionless contracting and necessitate careful institutional design and oversight.