June 20, 2006 to June 26, 2006
Privatizing Highways and Infrastructure
On Privatizing Highways and Other Functions--BECKER
There is a well-known conflict in privatizing a government enterprise between the desires to raise revenue from the privatization and to create an efficient enterprise. Government revenue is increased by giving the privatized company a protected position against competition, while allowing other companies to compete vigorously against the privatized company increases efficiency. Greater efficiency typically means lower prices for the privatized product, and hence lower bids for the enterprise to be privatized.
Governments often succumb to the desire to increase their revenue, which has caused the creation of monopolies in privatization programs all over the world. I differ with Posner in believing that the revenue from a monopolized privatization would not be fully raised elsewhere if not raised from the privatization because it is difficult to tap other sources of revenue to substitute for foregone revenues from privatizations. Put differently, governments end up with bigger total spending budgets when they increase their revenue from privatizations by giving privatized companies some monopoly power.
Still, I generally strongly support privatizations, even when privatized companies have monopoly power in setting prices and other conditions of the sale. The reason is that other companies are more likely to find ways to compete against private monopolies than against government ones. A very important part of this argument is that technological progress is faster with private monopolies than with public monopolies. For example, ATT was a private regulated monopoly before the breakup of the Bells in the early 1980's into competing entities. The breakup was desirable, but still ATT was much more efficient than were the government run companies that dominated the telephone industry at that time in the rest of the world.
These and the arguments given by Posner strongly imply that highways, along with postal systems, trains, airports, ports, and other infrastructure, including even some security activities, should be privately rather than publicly operated. The main challenge arises when it is more difficult to stimulate competition for the privatized company because of so-called "natural monopoly" conditions in the industry. Due to economies of scale, it may not be efficient, for example, to have another highway built across Indiana to compete against the Indiana toll road. Yet even in that case, it would still be desirable to privatize the toll road, but controls could be imposed on the prices and other conditions that can be levied imposed on consumers by the privatively owned road.
Yet I believe that in the dynamic world we live in, natural monopoly considerations are less common than often supposed because new technologies and processes can bring competition to what appear to be protected markets if the profits are large enough. In this way, the supposed natural monopoly position of traditional telephone companies due to the large fixed costs of a network of telephone wires has been eroded by the development of cable and its alternative wired network, and of course by wireless telephony and the use of the internet for phoning.
Roads and airports are examples of industries that pose greater challenges to create competition among private companies. However, smaller airports in a region, such as the one at Gary Indiana, would be expanded to attract business from higher priced dominant airport in the same region, like O'Hare, if the dominant airport was charging excessive fees, and if both airports were privately run. Even a second private toll road would be built to compete against at least part of a privatized toll road that was charging excessive fees, especially over the most densely traveled portions of the privatized road.
The theory of the efficient allocation of resources is radically changed when dynamic competition with induced technological progress is the framework of analysis instead of the traditional static theory of competition. Dynamic competition analysis is more comfortable with accepting short -term monopoly power of privatized enterprises that are allowed to set their own prices. The reason is that the monopoly profits from high prices by the privatized enterprise would stimulate other entrepreneurs to find ways to compete against the enterprise, and in this way claim some of the monopoly profits through lower prices and better service. "Natural monopoly" looms large in the theory of static allocation of resources, but is considerably less important in the actual world because of technological progress that is induced by monopoly power and excessive profits.
When dynamic competition is effective, a public enterprise, like a toll road or the postal system, should be sold without any restrictions on future pricing, unlike what happened in the sale of the Indiana toll road. I do not go so far as to claim that dynamic competition always arises in a powerful way to compete against privatized roads or other privatized infrastructure that have no restrictions on pricing. But I do believe it is far more common and effective than in textbook discussions of competition and entry. If that is the case, it would then pay to privatize most of the public infrastructure of roads, communication, mail delivery, electric power generation, and the like, with few controls over the prices that can be charged to consumers. That would create some pockets of persistent monopoly profits, but it would take politics out of rate setting. It would also stimulate the development of different ways to compete against what appears to be an unassailable monopoly enterprise.
Privatizing the Nation's Highways--and Other Infrastructure--Posner
The State of Indiana has just leased the Indiana Toll Road--a 157-mile-long highway in northern Indiana that connects Illinois to Ohio--to a Spanish-Australian consortium for 75 years for $3.8 billion, to be paid in a lump sum. (The deal has been challenged in the Indiana state courts.) The lease is complex, imposing many duties on the lessee (such as to install electronic toll collection, in which Indiana has lagged). A key provision is that the consortium will not be able to raise toll rates until 2016 (for passenger cars--2010 for trucks) and then only by the greatest of 2 percent a year, the consumer inflation rate (CPI), or the annual increase in GDP. (On the eve of the lease, Indiana raised toll rates--which hadn't changed since 1985--significantly.) Two years ago Chicago made a similar lease of the Chicago Skyway, an 8-mile stretch that connects Chicago to the Indiana Toll Road, for $1.8 billion. There is considerable interest in other states as well in leasing toll roads to private entities.
The idea of privatizing toll roads is an attractive one from an economic standpoint. Private companies are more efficient than public ones, at least in the limited sense of economizing on costs. I call this sense of efficiency "limited" because there are other dimensions of efficiency, for example the allocative; a monopolist might be very effective in limiting his costs, but by charging a monopoly price he would distort the allocation of resources. Some of his customers would be induced by the high price to switch to substitutes that cost more to make than the monopolist's product but that, being priced at the competitive rather than the monopoly price, seemed cheaper to consumers. (This is the standard economic objection to monopoly.) The reason for the superior ability of private companies to control costs is that they have both a strong financial incentive and also competitive pressure to do so--factors that operate weakly or not all in the case of public agencies--and that their pricing and purchasing decisions, including decisions regarding wages and labor relations, are not distorted by political pressures and corruption. There is a long history of price-fixing in highway construction and maintenance, attributable in part to bidding rules that, in endeavoring to prevent corruption, facilitate bid rigging. For example, if to prevent corruption contracts are always awarded to the low bidder, a bid-rigging conspiracy will always know whether one of its members is cheating, if the low bidder, who gets the contract, was not the bidder that the conspiracy assigned to make the low bid. If cheating on a conspiracy is readily detectable, cheating is less likely and therefore the conspiracy more effective.
The problem of allocative efficiency looms when, for example, there are exernalities; but the solution to the problem rarely requires public ownership. One significant externality associated with vehicular transportation is the congestion externality: no driver is likely to consider the effect of his driving on the convenience of other drivers, because there is no way in which he can exact compensation from drivers for not driving or driving less and therefore improving their driving time. That externality is internalized by a toll road, because congestion reduces the quality of the driving experience and so the amount each driver is willing to pay in tolls; the owner of the toll road will trade that willingess to pay off against the reduction in the number of drivers as a result of a higher toll.
Another externality, however, will not be internalized by the toll-road operators. That is the contribution that driving makes to pollution and global warming. But public ownership is not necessary in order to internalize this externality. The government can force its internalizing by imposing a tax on driving.
There is, however, in the toll-road setting another source of allocative inefficiency, and that is monopoly, which I have mentioned already. Drivers who do not have good alternatives to using the Indiana Toll Road can be made to pay tolls that exceed wear and tear, congestion effects, social costs of pollution, and other costs of the road, engendering inefficient substitutions by drivers unwilling to pay those tolls. To an extent, the toll-road operator may be able to discourage substitution by price discrimination, but this is unlikely to be fully effective and indeed can actually increase the allocative inefficiency of the monopoly.
The monopoly issue raises the question: what exactly was Indiana selling when it leased the toll road for $3.8 billion? The higher the tolls and the greater the lessee's freedom to raise the tolls in the future, the higher the price that the state can command for the lease. If the lease placed no limitations on tolls, the state would be selling an unregulated monopoly. If the lease could constrain the lessee to charge tolls just equal to the cost of operating the toll road (including maintenance, repairs, snow removal, lighting, and the collection of the tolls), the market price of the lease would be significantly lower. To the extent that the state wants to maximize its take from the lease, it will be creating allocative inefficiency by conferring monopoly power on the lessee.
It is difficult to determine whether the $3.8 billion price tag for the Indiana Toll Road is closer to the competitive or the monopoly price level. On the one hand, the lessee cannot raise tolls until 2010 or 2016 (depending on the type of vehicle), and increases after that are capped. On the other hand, the tolls were raised significantly just before the lease, and allowing the operator in 2010 to begin raising toll rates annually by the increase in GDP may confer windfall gains, since the cost of operating the toll road may not increase at so great a rate. One would have to know a great deal more about the economics of operating a highway than I do to figure out whether the terms of the lease confer monopoly power on the lessee.
I do not regard the monopoly concern as a strong objection to the leasing of the toll road, however. The reason is that most, maybe all, taxes have monopoly-like effects, in the sense of driving a wedge between cost and price. Suppose the lease price would have been only $2 billion had the state imposed more stringent limitations on toll increases. Then the state would have $1.8 billion less in revenue and would presumably make up the difference by increasing tax rates or imposing additional taxes, and these measures would have allocative effects similar to those of higher tolls charged by the lessee of the toll road. If the monopoly issue is therefore considered a wash, the principal effect of the lease will be the positive one of reducing the quality-adjusted cost of operating the toll road and the lease is clearly a good idea.
Toll roads are more attractive candidates for privatization than non-toll roads because it is easy to charge user fees; tolls are user fees. It would be harder to charge for the use of city streets, though no longer impossible, given electronic technology for monitoring drivers. Privatizing certain security services pose special problems as well, as Becker and I discussed in our May 28 posts about security contractors in Iraq. But public services the cost of which is defrayed in whole or significant part by user fees are good candidates for privatization, including Amtrak, the Postal Service, building and restaurant inspections, veterans' hospitals, and federal, state, and local airports. The privatization movement has a long way to go before achieving an optimal mixture of public and private service providers.
Against all this it will be argued--it is an argument emphasized by opponents of leasing the Indiana Toll Road--that privatization, at least when it takes the form of a sale or long-term lease of government property for a lump sum, beggars the future by depriving government of an income-producing asset. The argument, at least in its simplest form, is unsound, because the state is not disposing of an asset but merely changing its form: from a highway to cash. The subtler form of the argument is that, given the truncated horizons of elected officials, the state will not invest the cash wisely for the long term, but will squander it on short-term projects. This is a danger--how great a one I do not know. It would be an interesting study to trace the uses to which privatizing governments here and abroad have put the proceeds of sales of public assets.
Privatizing Highways--Posner's Response to Comments
There were a number of interesting comments; I limit myself to respomding to three. One is that the lessee overpaid; this is possible if the lessee is ambitious to acquire other U.S. highway systems and wants, and is willing to pay for, "first mover" advantages; other states will be more inclined to deal with a pivate highway operator who has a track record.
The second comment is that the private lessee of the Indiana Toll Road will have an incentive to skimp on maintenance in order to reduce costs and thus maximize profits. Notice the tension with the first point: if the lessee is ambitious to acquire additional highway systems, it will want to create a good reputation for honoring its maintenance obligations under the lease of the Indiana Toll Road. In Europe, which has a number of private operators of highway systems, maintenance has not been a problem, maybe because poor maintenance is quickly detected.
Third is the question of checks on abuses of monopoly power. Some commenters fear the monopoly power of the lessee of the Indiana Toll Road, others argue that the state could offset it by building a parallel road. Speaking from personal experience as a frequent user of the Indiana Toll Road, it has ample capacity even at existing toll rates, which means that the construction of a competing toll road is unlikely, since it would create excess capacity, and competition under conditions of excess capacity is likely to result in prices that do not cover total costs. One comment indicates that one term of the lease is a promise by the State of Indiana not to improve certain roads that run parallel to the Indiana Toll Road, and that promise would tend to secure the lesee's monopoly and thus increase the price of the lease. As I said in my post, while monopoly pricing has misallocative effects, so do taxes, for which the revenue from the lease may be a substitute.
Response on Privatizations-BECKER
I will briefly respond to some of the interesting comments.
Many politicians oppose privatizations because of the opposition from employees of the enterprises that might be privatized. Employees have opposed every single privatization that I am familiar with. The reason is clear: public companies have too many employees from an efficiency perspective, and the employees know this. Also they have to work harder for lower pay when their enterprise becomes private.
Windows has a large share of the market, but Apple, Linus, and other systems limit the power of Microsoft's Windows. Microsoft's power is in my judgment rapidly declining in the overall computer-internet market. This is one of the best examples of the difference between static and dynamic competition.
The USPO illustrates the worst of public monopolies. It has lagged virtually all the important mail delivery innovations in recent decades. It is grossly overmanned, and its employees are often surly and unpleasant. The need to subsidize mail sent to remote places is no justification for a public monopoly. Such mail can be subsidized-if that is desirable- without having a public monopoly. Simply subsidize Fed Ex or any one else for their deliveries to such places. Take away the protection of the law and subsidies, and the USPO would collapse within a short time.
Many public institutions in higher education offer very fine products, but that is because they face stiff competition from each other and from private universities. Eliminate that competition-as in Germany, France, or Italy- and one sees how ineffectual public universities become.
Phone service has become much cheaper, not more expensive, since the telephone market was opened up. It is far cheaper to make long distance calls, including international ones, than it was before. Imagine what the phone system would be like if ATT still had a monopoly: where would wireless, cable, and Internet telephony be? ATT would have used its political power to resist and handicap every one of these and other innovations.