The RAND Corporation
Regulation and Administered Contracts
Author(s): Victor P. Goldberg
Source: The Bell Journal of Economics, Vol. 7, No. 2 (Autumn, 1976), pp. 426-448
Published by: The RAND Corporation
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Regulaffon
and administered
contracts
Victor P. Goldberg
Associate Professorof Economics
Universityof California,Davis
This paper explores the ramificationsof introducingadministered
contracts-long-term,collective contractual relationships-into economic analysis with attentionbeing focused on the implicitregulatory contract. The perspective afforded by the administered con1tractsframeworksuggests that the economist's case against regulation has been overstated. Many of the problems associated with
regulationlie in what is being regulated,not in the act of regulation
itself. Further, many of the perceived failures of regulation (for
example, entryrestrictions)can be seen to have a plausible efficiency
rationale.
1. Introduction
THE BELL JOURNAL
426/ OF ECONOMICS
a The failureof regulationhas been widelychronicledin recent
years.1Extensionof publicutilityregulationinto new areas-e.g.,
from
widespreadopposition
and hospitals-callsforth
cable television
of a
for deregulation
economists(and others)and the momentum
numberof activitieshas been building.However,regulation'slow
proaboutthe regulatory
reputeis in partbased on misconceptions
cess and the privatecontractalternatives.
a differoffering
In thispaperwe presenta conceptualframework
choice. The emphasis
and institutional
entperspectiveon regulation
is on aspects of contractualcomplexitytypicallyglossed over in
The
(andeconomictheorygenerally).
economicanalysesofregulation
contractof economictheory(and of law)2is a discrete
paradigmatic
object(theeverpopularwidget)
a well-defined
conveying
transaction
is adequate for many
in exchangefor cash. This characterization
fromsome aspectsof contractthat
purposes,butit divertsattention
context.Thisdiscrete
significance
in a regulatory
willbe ofparticular
forrepresentinappropriate
moldis apt to be singularly
transactional
ingrelationswhichare to takeplace overa longperiodoftimeand in
over a
whichthepartieswillhave to deal witheach otherregularly
fromthePublic
fellowship
bya post-doctoral
supported
Thisresearchwas partially
The authorwould
and StateUniversity.
Institute
Polytechnic
ChoiceCenter,Virginia
GeorgeBerger,PaulJoskow,
on earlierdrafts:
forcomments
liketo thankthefollowing
Blair Lord, Ian Macneil,Alan Olmstead,JohnRoemer,WarrenSamuels,Kathy
An earlierversionof
Swartz,GordonTullock,David Warner,and OliverWilliamson.
andPublicUtilities
at theSeminaron ProblemsofRegulation
thispaperwas presented
College.August5, 1975.
heldat Dartmouth
is nearlyuniversal;
I "Amongeconomists
forregulation
thedisdainand contempt
and if ineffective,
a wasteof resources"
to be pernicious,
it is thought
if effective,
(Dewey,1974,p. 10). See also MacAvoy(1970,p. viii)and GreenandNader(1973,p.
case, see Posner(1969).
of theantiregulation
881); fora detailedstatement
paradigmin the
2 For a detaileddiscussion
of theroleof thediscretetransaction
see Macneil(1974);fordiscussionof someoftheeconomicimplicalaw of contracts,
tions,see Goldberg(1976a).
widerangeof issues (manyof themunknownin advance).A second
suppressedproblemconcernsthe relianceof individualson agents
(forgathering
information,
makingdecisions,negotiating
contracts,
adjustingthetermsof ongoingrelationships,
and so on). It is convenientto distinguish
thediscretetransaction
oftraditional
theoryfrom
contractswhichexhibitprominently
one or the other(or both) of
theseelements-anongoingrelationship
and agency.Such contracts
willbe called"administered
contracts."3
Regulation
can be viewedas
an implicitadministered
contractin whichboth elementsare significant.4
By attempting
to analyzeregulation
withina discretetransaction
framework,
economistshave suppressedthe mostsignificant
aspects
oftheregulatory
and thishas led to an overstatement
arrangement
of
thecase againstregulation.
First,thatframework
generatesthewrong
criteriaagainstwhichregulationis to be evaluated.Second, when
viewedin an administered
contractsperspective,
regulatory
policies
thatwouldappearindefensible
in a discretetransactions
worldcan be
seen to have a (loose) efficiency
a failureto
rationale.And finally,
in theprivate
of contractual
appreciatethecomplexity
arrangements
sectoris aptto leave theanalystundulysanguineas to theefficacy
of
privatemarketsolutionsto problemsin the regulatory
sector.
The argument
below shouldnotbe construedas a briefforwallto-wallregulation.
Nor shouldit be takento meanthatcurrentregulatorypoliciesare the best we can do. They are not. The pointis
in seriouslyanalyzingregulation
and
simplythatif one is interested
it is necessaryto open up the "black
otherinstitutional
alternatives,
box" of contract.
c Beforeanalyzing
thecomplexities
thatarisein a worldofadministeredcontracts,
it is usefulto elaborateupon someof theaspectsof
sucha world.We beginthissectionbyexpanding
uponthedistinction
betweenthediscretetransaction
and theongoingcontractual
relationship.We thenturnto a discussionofagencyand therelatedissuesof
the nestingof contractualrelationships
and the blurredborderline
betweenprivatecontractand social contract.Next we introducea
convenientsimplification-the
notionthatthe agentis puttingout a
bid fora long-term
contractforthe rightto servehis constituency.
Finally,we will make some remarksconcerning
the difficulties
entailedin developingsatisfactory
welfareor efficiency
criteriain an
administered
contractsframework.
2. The
administered
contracts
framework
O Relationalcontracts.The pure discretetransactionof economic
theoryinvolvesthe contemporaneous
exchangeof claimsor rights
I Purediscrete
transactions
existonlyas theoretical
abstractions.
Allcontracts
will
haveat leastsomerelational
andagencyaspects(as willbe madeclearinthefollowing
section)and it mighttherefore
be betterto eliminatethe "administered
contract"
terminology.
We prefer,
however,to use it nowto emphasizethedistinction
between
contracts
in whichtherelational
and/oragencyaspectis important
and thenarrower
contracts
implicit
in mosteconomictheorizing.
4 In thenextsection
we shallbroadenthenotionoftheagencyrelationship
so that
it willbe unnecessary
to distinguish
betweenactualcontractual
relationships
(those
explicitly
recognized
as creatingcontractual
duties)and implicitcontractual
relationships.
GOLDBERG
/ 427
of thepartiesand the
parties.5The identity
betweenthe contracting
are irrelevant.
is
consummated
contract
which
the
within
socialmilieu
withone partysellingto the
The exchangeis cloakedin anonymity
marketand the otherbuyingfromthe market.This is an extreme
caricatureof contractand in its purestformit has no real world
Contracttypicallyinvolvesthe projectionof exchange
counterpart.
exchangeas a special case.
intothe future,withcontemporaneous
on
Enteringintoa contractwillgenerallyentailplacingrestrictions
parties'futureoptions.Freedomof contractis the
the contracting
on one's futurebehavior.6
freedomto imposerestrictions
of the durationof the
For a wide rangeof activities,recognition
wouldadd
of the futurerestrictions
contractand the extensiveness
For manyotheractivities,
to theanalysisbutlittleinsight.
complexity
thenatureof therestrictions,
however,thelengthof theagreement,
stage7
oftheissuesarisingbetweentheformation
and thecomplexity
Consider
willbe ofcrucialinterest.
and itstermination
ofthecontract
relationin designing
contractsto deal withlong-term
thedifficulties
of complexdefense
ships such as developmentand procurement
of a chemicalplant embodyingsubstantial
hardware,construction
or
stateof the art advances,joint ventures,franchiseagreements,
Whilethepartiesmightwantto go intoconsiderabledetail
marriage.
the rightsand obligationsof each
at theformation
stageconcerning
it willoftenprovetoo costlyto
partygivenvariouscontingencies,8
specifythe precise termsof the contractand it will be desirable
insteadto use roughformulaeor mutualagreementto adjust the
As the relationalaspectsof the concontractto currentsituations.9
emphasiswill shiftfroma detailed
tractbecome more significant,
to a moregeneralstateof the termsof the agreement
specification
mentof the process of adjustingthe termsof the agreementover
the
governing
in effect,of a "constitution"
time-theestablishment,
ongoingrelationship.10
D Agency.Frequently
firm-engages
one partyto a transaction-the
THE BELL JOURNAL
428 / OF ECONOMICS
I For a detailed discussion of the characteristicsof discrete transactions and
relationalcontracts,see Macneil (1974, pp. 735-805).
6 See Clark (1939. p. 87) and Macneil (1974, p. 810).
7 In contractualrelations,rightsand duties oftenarise beforethe formation
stage of
the contract. In civil code countries,the obligationto bargain in good faithhas long
been explicitlyrecognized. Kessler and Fine (1964) show that this continentallaw
doctrineis not totallyforeignto commonlaw jurisdictions.See, forexample, Hoffman
v. Red Owl1 Stores, Inc., 26 Wis. 2d 683. 133 N.W.2d 267 (1965).
8 For examples of some attemptsto specify at least some of the terms of the
marriagecontract,see Weitzman(1974, pp. 1278-1288).
9 For a discussion of some of the factorsmakinglong-term,incompletecontracts
desirable, see Williamson (1971, 1973, 1974), Macneil (1974), and Goldberg (1976a).
Coordinationby long-termcontractblends into coordinationby verticalintegration.It
coordinationmechanismsthat are strongerand more
is not hard to imagineinte,tfirnm
mechanisms. The convenient
accepted by the relevant parties than some intr-afirm
fictionof economic theorythat monolithicfirmscoordinateinternalbehavior perfectly
and engage only in discrete. anonymous contracts with external parties leads us to
ignore the great similaritiesbetween internaland external coordination. For an apcoordination,see Richardson (1972).
proach which stresses interorganization
10The constituLtion
can be in large partimplicit,being definedlargelyby the social
(and legal) context within which the agreement was made. The standard marriage
contractprovides a good example. The general question of the nestingof transactions
in deeper relationshipsis discussed brieflyin Section 2 and in more detail in Macneil
(1974).
witha large numberof otherparties-the
in similartransactions
The
consumers-whoeach enterinto veryfew such transactions.
will,in manyinstances,findit desirableto act collectively
consumers
the
an agentbothto negotiatethe termsand to administer
through
employeeswillfindthat
overtime.In an analogoussituation,
contract
contractswhichdetermultiyear
a unioncan fillthisrole,negotiating
a
and also providing
conditions
and working
minebothcompensation
methodforseeingthatthetermsof thecontractare adheredto (or a
means for changingthe workingconditionswithoutreopeningthe
contract).
as beinggovernedby conWe can view individualtransactions
with
tractson (at least)twolevels.The providerentersintocontracts
of
these
interpretation
and
the
content
with
individualcustomers
contractsgovernedby anotherlevel of contract-thecollective
can also be
theproviderand theagent.Regulation
contract-between
the regubetween
contract
implicit
in
the
with
viewed thismanner
agencyservingas thecollectiveconlatedfirm(s)and theregulatory
we
thanthis.Conceptually,
tract.1"Indeed,we can go muchfurther
and revisingthe
can treatjudges and legislatorsas agentsenforcing
take place. Thus, the abrulesunderwhichindividualtransactions
contractdoes not precludeus from
sence of a formaladministered
as ifitweregovernedbysucha
a certainsetoftransactions
analyzing
can be viewedas a
contract.For example,thelaw ofproductliability
the termsunderwhichnumerousindicollectivecontractgoverning
changesovertimein the
further,
vidualcontractsare consummated;
by theagents
law can be viewedas efforts
contentofproductliability
to adjustthetermsof thecollectivecontract
(courtsand legislatures)
to changingcircumstances.12
howeverwell definedtheymight
In this sense, all transactions,
jurispatternof contractual
appear,are nestedin a complexshifting
of
establishtherightsand obligations
dictionswhich,takentogether,
of
therespectivepartiesand theroles of the agents.The structures
transactions
can, of course,
particular
the set of contractsgoverning
of the agentsto theirclienThe responsiveness
differsubstantially.
betweenagents,and the freedomof
tele, the divisionof authority
all willvary.13
Nevertheless,
to shiftbetweenjurisdictions
individuals
to the factthatthe problemsof
does call attention
thisformulation
specific
commonlaw rulesforgoverning
theappropriate
determining
willin manywaysbe analogousto theproblems
sets of transactions
" There is no reason for the collective contractto be explicitlyrecognized as a
valid contract.Indeed, even ifit has no legal recognitionit mightstillbe of tremendous
practicalimportance;see, forexample, Friedmann'sdiscussion of collectivebargaining
agreementsin Great Britain(1951, pp. 26-27).
12 Brown (1974, p. 149) notes that the common law can be treatedas a standard
The commonlaw is
interpretation.
formcontract.We are suggestinga slightlydifferent
embedded in a social contractwhich establishes a procedureforadjustingthe specific
terms of the contractover time.
13 Agency relationshipsmightbe very short-livedand mightinvolve small numbers. Single individualsor small groups mightengage agents to customize services for
them(e.g., stock brokersor trustees).One partymightsometimesact both as a partyto
the transactionand an agent for the other party(e.g., a doctor or a departmentstore
in effect,the product's quality). Since in the contextof regulationwe shall
certifying,
generallybe more interestedin long-runcollective agency relationships,these qualifications will generallynot be of much importancein thispaper. They can, however,be of
much greaterinterestin a general theoryof agency. For an exhaustive taxonomyof
agency concepts, see Mitnick(1974).
GOLDBERG
/ 429
facedbyregulators
and otheradministrators
ofcollectivecontracts.
It
also emphasizesthatprivateexplicitcontractinevitably
blendsinto
implicitsocial contractof whichregulation
is but a special subset.
Finally,it providesus withan individual-theagent-on whomwe
can focusourattention.
Thattheagentmightbe a fictitious
character
does not detractfromhis pedagogicvalue.
We shallassumethroughout
thattheagentis a faithful
representativeofhisprincipals'interests.
Whilea wildlyunrealistic
assumption,
thebenevolentagent,like thebenevolentdictatorof traditional
welfareeconomics,is a convenient
analyticalconstruct.
Thisassumption
does, however,precludediscussionof the politicsof regulationparticularly
the chargethat regulatorsare susceptibleto political
influence
byproducerinterests.14
It is indeedtruethattheinstitutions
of regulation
are subjectto politicalabuse. We mustbear in mind,
however,thatall institutions,
including
thoseofprivatecontract,
are.
It is by no meansobviousthatintegrating
politicalconsiderations
into
the analysiswill makeregulation
a relatively
less attractive
alternative; detailedinvestigation
of thatpoint,however,is beyondthe
scope of thispaper.15
How mightwe modeleconomicprocessesin a worldin which
agencyis important
and restrictions
on entryinto (and exit from)
jurisdictions
are pervasive?One possibility
wouldbe to takea general
Walrasianapproach.This, however,is apt to be uninequilibrium
teresting
or impracticable.16
Insteadwe shallfocuson thedecisionsof
an agentwitha fixedconstituency;
thisis roughly
to
thecounterpart
Marshallianpartialanalysisin an agencyworld.(As we shall see in
the next section,however,the analysishas strongSchumpeterian
overtones.)17
E A biddingforthe marketparadigm.To facilitate
analysis,we shall
focuson an agentwho mustdevise,putout to bid, and administer
a
collectivecontractfortheprovisionof electricity,
telephoneservice,
or some otherso-callednaturalmonopolyindustry.
The assumption
thatthereis a uniqueformation
stageforthecollectivecontractdoes
some violenceto reality,particularly
for some of the more subtle
relationalcontracts(e.g., the implicitcontractof the commonlaw).
The assumptiondoes, however,greatlysimplify
the discussionand
usefully
centerson thedecisionproblemofthebenevolent
agentwith
18
a definedconstituency
(or jurisdiction).
See, for example, Bernstein(1955), Stigler (1971), and Posner (1974).
For a more detailed discussion of the politics of regulationand privatecontract,
see Goldberg (1974); see also Galanter (1974).
16
It is doubtfulthat sufficientinstitutionalcontent can be introducedinto such
models to make themveryinteresting.On a more heuristiclevel, however,the studyof
"appropriate jurisdiction" mightyield useful insights. For example, if most health
insurance is provided throughgroup insurance,then we mightask whetherthe group
administratoris the appropriateagent for all aspects of the contractor whethersome
decisions should be left to "lower" agents or reserved for "higher" agents. An
example of the formerwould be givingthe individualmembera choice of insurersor
insurancepackages; an example of the latterwould be a legislativeor judicial rule that
the insurancecoverage does not lapse forone year afteran individualhas been laid off.
For a discussion along these lines, see Lord (1975).
17 A thirdapproach, whichis largelyignoredhere, would be to focus on the agent's
problems of buildingand maintaininghis constituency.
18 Certainlythe initialbiddingabstractionwould appear far less objectionable than
the conventionalWalrasian fictionof an auctioneer quoting prices.
14
15
THE BELL JOURNAL
430 / OF ECONOMICS
Demsetz'9 relies on biddingforthe whole marketin his debunking
of the standardnaturalmonopolyjustificationfor regulation-namely
the allegation that there mightbe room for only one efficientproducer. The fact thattechnologyrequires thatonly one producerexist
does not preclude an initialbiddingcompetitionforthe rightto be the
sole provider.If collusion among bidderscan be avoided, competitive
bidding"for the field" should eliminatemonopolyprofits,since any
bidderwho included monopolyprofitsin his bid would runthe riskof
beingundercut.Expected profitswould, therefore,be zero and, since
Demsetz assumes away risk and uncertainty,there will be no risk
premium.Thus, competitivebiddingsolves half the monopolyproblem: excessive profits. However, if this solution entailed merely
equating price and average cost, there would still be misallocation
since, withdecreasing costs, price would exceed marginalcost. This
second problem can be solved, as Demsetz implies, by adopting a
multiparttariff,chargingthe consumers marginalcost plus a lump
sumjust sufficient
to yield the providera normalprofit.Thus, thereis
no reason in principle that a natural monopoly industryneed be
inefficient.
This argumentassumes away problemsdue to riskor transactions
costs to focus attentionon the logical inconsistencyof the narrow
natural monopoly rationale. Of course, as Demsetz has shown
elsewhere, if we can assume away risk and transactionscosts, then,
as long as there is freedomof contract (that is, the state does not
artificially
set some transactionscosts greaterthan zero), the private
marketwill always yield efficientoutcomes. Monopoly, forexample,
would not be inefficient,since consumers could (costlessly) band
togetherand bribe the monopolistto set price equal to marginalcosts
even if there were no potentialcompetitors.20
The demolitionof the naturalmonopoly rationaleis not merelya
testimonialto the power of the "zero transactionscost" assumption.
The argumenthighlightsthe fundamentalsimilaritybetween regulation and a private contractfor the rightto serve. It furthersuggests
that in searchingfor a rationalefor regulationwe should look not at
the shape of the long-runaverage cost curve, but instead at the
complexitiesinvolved in devisingand administeringsuch a contract.
Indeed, natural monopoly industries will be characterized in this
paper not by theiralleged decreasing average costs, but by the features which make long-termrelationshipsbetween consumers and
producers desirable and which furthermake it extremelydifficultto
determineat the outset the specific terms of that relationship.
O Desiderata. Working within the discrete transaction paradigm,
economists have developed an elaborate and elegant optimization
frameworkwhich provides a rigorous definitionof economic efficiency.In an administeredcontractsworld we are not so fortunate.
We must firstconcede that even if the agent were to performperfectly, the outcomes need not be socially desirable-there is no
reason to presume thatdecision-matinghas been decentralizedalong
the properlines. That is the price we mustpay forconfiningourselves
to partial analysis.
Demsetz (1968); for a critical discussion of Demsetz, see Williamson(1976).
See Demsetz (1966, p. 64). For a discussion of some of the conceptual difficulties thatarise in a zero transactionscost world, see Goldberg (1976a, pp. 46-48).
19
20
GOLDBERG
/ 431
weights
give appropriate
or implicitly,
The agentmust,explicitly
of his clientele-thatis, he mustsomehowconto the preferences
structa partialsocial welfarefunction.Further,he mustascertain
are ill-defined-aswouldbe
and wherepreferences
thosepreferences
be called
contracts-theagentwill,ineffect,
commonin administered
will
grouppreferences.21Hence,welfarecriteria
uponto manufacture
of reasonable
and characterization
be based on theagent'sweighting
preferences.
paradigm,the partiesare concerned
In the discretetransaction
withthe priceand quantityof clearlydefinedinputsor outputsand
decisionsaccordproduction
or consumption
maketheiroptimizing
contract
stageof an administered
ingly.The agentat the formation
confronts
a farmorecomplexproblem.The longerthe antypically
entailedin
and uncertainty
ticipatedrelationand themorecomplexity
will be placed on the price and
thatrelation,the less significance
stage.The emphasiswillinstead
quantityvariablesat theformation
rulesdetermining
rulesto governtherelationship:
be on establishing
theprorulesdetermining
lengthof therelationship;
theappropriate
to unexpectedfactorsthatarise in the courseof
cess of adjustment
ofthatrelationthetermination
and rulesconcerning
therelationship;
ship.
applythe logic of
One can, withsuitablecautionand humility,
to aspects of the agent'schoice problem.Indeed,one
optimization
the problemas we have is to facilitatesuch
reasonforformulating
analysis.Thus, by holdingotheraspectsof the problemconstant,it
theoptimallengthof a contractas a
shouldbe possibleto determine
functionof certainparameters(such as the exogenous rate of
inthediscussionthatfollowswe
change).Nevertheless,
technological
shall shyaway fromattempting
to developany rigorouscriteriafor
and shall insteadcontentourselveswithjudgingarrangeefficiency
of efmentsby some "reasonable" criteria.Such a nondefinition
ficiencywill not sit well withmosteconomists.Havingscaled the
to
it is difficult
and a bitanticlimactic
dizzyingheightsof optimality,
have to plumbthe murkydepthsof reasonableness.
3. Protecting the
producer's right to
serve
THE BELL JOURNAL
432 / OF ECONOMICS
realizethatsuccessful
biddersfora contract
O Supposethatpotential
requiresthemto installlong-lived,specializedcapital
performance
thathas a verythinresalemarket.Theirbidwilldependin
equipment
the futureavailabilityof that
parton theirexpectationsconcerning
by the exismarket.These expectationswill,in turn,be influenced
on the consumers'abilityto exit. The investtence of restrictions
and the
mentmight,however,proveto be a seriousmiscalculation
winnermightfindthatit cannoteven cover variablecosts. Then
In thisevent,makwouldbe cheaperthancontinuation.
termination
thecontractwillenhancethe
ingit easierforproducersto terminate
(lowerthesupplyprice).Hence,the
ofthearrangement
attractiveness
21 Alternatively
theprincipal'strue
we could say thatthe agentmustdetermine
betweenhis
preferences
and then,giventheprincipal'signoranceof the relationship
preference
mappingand the choice set, the agentmustattemptto constructthat
mustdelegatemuchofthe
relationship.
Thus,in a worldin whicha rationalprincipal
to agents,we cannotjudge the success of the agents
taskof evaluatingalternatives
oftherelationship
betweenthe
perceptions
againsta standard
based on theprincipal's
to be derivedtherefrom.
availablealternatives
and his utility
producerswill findthatrestrictions
on eithertheirbehavioror the
consumers'behaviorwill affecttheirsupplyprice.
Consumersare in a similarposition.To take advantageof a particularservicemightrequiretheinstallation
oflong-lived
complementaryequipment.The consumermightbe reluctantto purchasean
all-electric
houseifhe has no assurancethatelectricity
willbe available at "reasonableprices" overthe lifeof thehouse. On theother
hand,theconsumerwillwantto avoid beinglockedintoan inferior
technology;
forexample,he might
wanttheflexibility
to transmit
data
by microwaveratherthantelephonelines if he were to see fit.
Increasing
theprotection
oftheproducer'srightto servewillmake
the contractmoreattractive
to producersbut, ceterisparibus,will
makeit less attractive
to consumers.Likewise,increasedprotection
oftheconsumers'rightto be servedwillbe valuedby consumers
and
be treatedas an additionalcost by producers.Thus,at theformation
stagetheagentmustdetermine
theappropriate
protection
forboththe
rightto serveand the rightto be served.
Considerthefollowing
stylizedexample.The providercan name
onlyone pricethatis fixedforthedurationofthecontract.Consumin protecting
ershave no interest
theirrightto be served.(Therefore,
the produceris freeto terminate
at will.)22Potentialbiddersknow
thatas the durability
of the plantincreases,the marginalcosts of
at any time,howproduction
will fall;if the contractis terminated
wantto
ever,thescrapvalueoftheplantwillbe zero.The consumers
maintaintheirfreedomto terminate
the agreement
so thattheycan
as they
take advantageof lowerpricesand/orsuperiortechnologies
appear. The onlyvariableunderthe agent'scontrolis the level of
protection
of the rightto serve.23
The optimalprotection
willbe thatat whichtheexpectedmarginal
and decreasedprobenefits
to theconsumersof increaseddurability
costs
ducerrisk(lowerprices)arejust offset
bytheexpectedmarginal
If the optimalprotectionis substantially
of decreased flexibility.
greaterthanzero, thismeansthatthe agentfindsit in the long-run
theeffective
interest
ofhisprincipals
to restrict
theirfuture
options;24
achievementof theirlong-term
interestsrequiresthat barriersbe
erectedto theirpursuitof short-run
self-interest.25
Observation
ofprivatecontracting
partiessuggeststhattheyoften
willprovidesuchprotection
in theircontracts.Long-term
commercial
leases, requirements
contracts,and exclusivedealingcontractsare
Pricedetermination
in long-term
contractswillbe discussedin moredetailin
oftheconsumers'rightto be servedwillbe discussedin Section
Section4. Protection
5; fora detailedanalysisof therightto be served,see Goldberg(1976b)
23 Protection
dependson boththe lengthof the contractand the penaltiesfor
breachat any timeduringthe life of the contract.It is assumedforexpositional
convenience
thatthesecan be aggregated.
24 It shouldbe remembered
thattheveryessenceof contract
is therestriction
of
future
options.It is theeconomist'sfailureto takecognizanceofthatfactwhichleads
of long-term
to thetreatment
on behavioras aberrational.
restrictions
25 Formalmodelsof the agent'schoice problem
can be extendedto take into
accountsuchcomplications
as (1) consumer
relianceon thecontinuan6e
oftherelationship(protection
oftherightto be served),(2) morecomplexpricing
formulae,
and (3)
interactions
withinsuranceor alternative
riskspreading
devices.Whileinsurancewill
forrestrictions,
itcan also be a complement;
itmight,
forexample,
oftenbe a substitute
be besttoinsureagainstsomecontingencies
clauses
and to includerestrictive
contract
to controlinsurancepremiums.
22
GOLDBERG
/ 433
commonly
observed.26
Liquidateddamagesforpremature
termination
or cancellationare also common.27
For example,forsale of nuclear
powerplantsGeneralElectric'scataloglistedtermination
chargesin
1974beginning
at $72,000per month.28
The naturalmonopolysector
has characteristics
whichgenerally
makeprotection
oftheproducer's
relianceespeciallyattractive-very
highcapital-output
ratiosand capitalwhichis bothextremely
long-lived
and relatively
immobile.29
It is
therefore
reasonableto expectthattheagentwoulddesigncontracts
withsubstantial
protection
of theproducer'srightto serve.
The factthatsuch protectionwould be desirablefromthe consumer'spointof view has important
implications
fortheanalysisof
regulation.30
Two closelyrelatedcriticisms
of regulation
are thatit
undulyrestricts
entry31
and thatit discouragestechnological
change
26 In practice,these
oftenprovidemuchless protectionthan theyappear to
provideon paper. See the commentsof businessmen
in ColumbiaNitrogenCo. v.
RoysterGuano Co. 451 F.2d 3 (4thCir. 1971).On theotherhand,it is probablethat
meaningful
long-term
contracts
wouldbe morecommonwereit notfortheirpossible
conflictwith the antitrustlaws. See Standard Oil Co. of California v. United States,
337 U.S. 293 (1949) and FTC v. Motion PictureAdvertisingCo., 344 U.S. 392 (1953).
27 Courtswillrefuse
to enforcewhattheyregardto be penaltyclauses.The line
betweenunenforceable
penaltyclausesand enforceable
liquidateddamageclausesis a
fuzzyone. See DawsonandHarvey(1969,pp. 19-34)andMacneil(1975,pp. 699-702).
28 Kwitny
(1974,p. 39). In 1973Combustion
wona seriesofcontracts
Engineering
in whichit dramatically
increasedthecustomer'sfreedom
to backout ofdeals. While
theincreasedfreedom
(reducedprotection
oftherightto serve)might
ultimately
prove
desirable,it is clear thatCombustion
Engineering
has exposeditselfto substantially
greaterrisks.The WallStreetJournal notesthecompanyofficers
and directors
were
heavysellersof the stockin 1973.It further
states:
WithinCombustion,
the debateovertheseriskshas grownso hotthata contracting
executivehas come to thisnewspaperwithdocuments
thenewcontracts.
describing
He arguesthatthe risksare unacceptableand could cost Combustionhundredsof
millions
of dollarswithin
a decade.He showsevidencethatothersin thecompanyare
worriedtoo (Kwitny1974,p. 38).
29 It couldbe
arguedthatthesecharacteristics
are theresultofprotective
regulation.Indeedtheargument
in thefollowing
ofthe
footnote
suggeststhattheprotection
rightto servewillgenerally
lead to morecapitalintensive
production
Thus
techniques.
we are implicitly
assumingthatiftherewereno protection
fortherightto serve,the
efficient
ratiowouldstillbe veryhighor if thatis not the case, the
capital-output
optimaltechniquewouldbe extremely
expensive.For mostoftheindustries
generally
classifiedas naturalmonopoliesthatwouldseem to be a reasonableassumption.
30 The discussion
in thetextfocuseson growth
andinnovation
andignoresinternal
issuessuchas theinfluence
ofregulation
efficiency
on factorproportions;
The analytical framework
can be extendedto encompasssuchissues.For example,it seemsclear
thatthelevelofprotection
oftheright
to servedoes influence
thechoiceofproduction
techniques.As protection
is increased,producerswilladopttechnologies
whichtake
ofthisincreasedprotection
advantage
andthiswillalmostcertainly
leadto theadoption
of morecapital-intensive
techniques.The choice of flexiblepricingrules(to be discussed in the next section)can also influencefactorproportions
decisions.The
Averch-Johnson
(1962)modelwouldbe a specialcase in whichtherightto servehas
absoluteprotection
(entryis blockaded)andin whichrateofreturn
pricing
than
(rather
some otherflexiblepricingmechanism)
is used. In thisbroadenedcontextthe A-J
resultmustbe reinterpreted.
overcapitalization
of the
The optimalfactorproportions
A-Jmodelwillnot(exceptby accident)be optimalwhenwe take intoaccountthe
factors
thatmakeflexible
and protection
oftheright
to serve(andtheright
to be
pricing
served)attractive.
(It shouldbe notedthatthereare otherreasonsfornottakingtheA-J
implications
seriously;see Joskow(1974).)
3' Posner(1969,p. 612) forexample,states:
THE BELL JOURNAL
434 / OF ECONOMICS
Butlimitations
on entryare worsethansuperfluous;
theyconstitute
a barrier
to entry
that may perpetuatemonopolylong aftera markethas ceased to be naturally
monopolistic.
technologies.32
by protecting
existingproducersfromcompeting
To
in a discrete
be sure,suchlimitations
on entrymustappearinefficient
transaction
world.Entrybarriersdo enabletheproducerto chargea
higherprice in the shortrun than he could withoutthe barriers;
likewise,theregulator
who,forexample,protectsUHF stationowners fromCATV competitionis undoubtedlyin errorwithinthis
analysisignorestheimportance
of the
framework.
But thisshort-run
protection
of the rightto serve. Wouldthefirmhave corneintothe
fromcompetition?
Wouldit
marketinitially
withoutsome protection
have comein on termsas favorableas itdid?Whatwillbe therateof
supplyof innovations
in thefutureifpotentialsuppliersrealizethey
willnotbe protected
Thatis, ifwe viewtheprotecby theregulator?
agentasforwardlooking,we can see it
tionafforded
by theregulatory
Restrictions
on entry
as a goad to innovation
ratherthana hindrance.
technologies
providea (possibly
by firms
withidenticalor competing
gale ofcreativedestruction.
beneficial)
havenfromtheSchumpeterian
Schumpeter33
put the pointeloquently:
. . .restrictions. . . are, in the conditionsof the perennialgale, incidents,often
processof expansionwhichtheyprotectrather
unavoidableincidents,
of a long-run
thanimpede.Thereis no moreofa paradoxinthisthanthereis in sayingthatmotorcars
are traveling
fasterthantheyotherwise
wouldbecalse theyare providedwithbrakes.
Thus, a regulatoractingas the consumers'agentwould desire
some shieldingof existingproducersfromcompetingtechnologies.
Regulation
could,perhaps,be criticizedfordoingtoo muchshielding
first
or shielding
thewrongproducers,butto be validsuch criticism
the
thatenablesus to determine
requiresthatwe adopta framework
appropriate
restrictions
on producersand consumers.3
Even if it is true that regulationis too protectiveof existing
technologies,thereis no reason to presumethatprivatecontract
would lead to the optimalamountof protection.The consumers'
privateagentwill adopt some of the same practicesas would the
regulator
(publicagent).We can thussuggestfourpoints.First,some
technology
suppressionwilllikelybe desirablefromthe consumers'
of the
determined
identity
viewpointregardlessof the institutionally
arrangements
relyingon privateagents
agent.Second, institutional
similarto thoseemployed
mechanisms
willfrequently
haverestrictive
in regulatedindustries.Third,if theydo not employsuch mechrules to
anisms,theywill oftenrelyon a mixedbag of substitute
thesamegoal-patents,3tradesecrets,and creation
achieveroughly
entrythatseemsat all appealing. . . is thata
forregulating
The onlyjustification
may fail to materializedue to the
truemarkettest of a new entrant'sefficiency
rates.
agency'spowerto prescribeminimum
regulatory
32 See, forexample,Greenand Nader (1973, p. 881), Kahn (1971, pp. 32-45),
Posner(1971,pp. 29-30),and Noll (1971,p. 25).
33 Schumpeter
urgedto read thetwo para(1950,p. 88). The readeris strongly
the quotedmaterial.
graphspreceding
34 In termsof policy we shouldbe concernednot only withthe appropriate
that
restrictions
thatfacilitateremoving
mechanisms
but withdesigning
restrictions
protection
no longerservetheirpurpose.For an analysisalongtheselinesconcerning
of the rightto be served,see Goldberg(i976b).
of therightto serve.Duringthelifeof the
manisfestation
35 A patentis another
patent,thepatenteehas theexclusiverightto sell theproductand can enjoinothers
to protecthis claim).In an institufromdoingso or collectdamages(ifhe can afford
thepropermixoflegal
determining
contexttherearegreatdifficulties
tionalengineering
the rightto serve. It shouldbe clear,however,thatall such
devicesforprotecting
GOLDBERG / 435
of property
rightsin customersare examples.36Finally,sometimes
privatemarketmechanisms
willsimplynotbe adequateand theprivate marketwill failto providegoods and servicesthatwould(and
should) be made available under alternativeinstitutional
arrangements.3
7
4. Flexible pricing
* Considertheoptionsconcerning
pricingarrangements
open to an
administrator
of a long-term
contract.One optionis simplyto charge
a lump-sumpaymentpayable at the beginningof the periodwith
goods and servicesthenprovidedcostlesslyduringthe periodthe
contractis in force.An almostequivalentalternative
would be to
providefora fixedannualpayment.If thebuyerhas access to capital
at bettertermsthanthe potentialsellers,it is to his advantageto
and to pay thesupplierup front.If thecontract
acquirethefinancing
were terminated,
thenthe buyermightfindthe task of attaininga
refund
moredifficult
(andexpensive)thanthetaskofceasingpayment
and would therefore
preferannualpayments.But aside fromsuch
relatively
minorissues,thesetwo optionsare rathersimilar.A third
optionwouldbe to establisha priceschedulefixedforthedurationof
the contract.The schedulecan entailall sortsof complexarrangements-two-part
tariffs,
quantitydiscounts,cash discounts,and the
factoris thatthe priceschedule,no matter
like. But the significant
how complex,is agreedto whenthe contractis signed.
Another
optionwouldbe fortheagenttoleave thepricetermopen
to varyingdegrees.Ratherthanspecifyfuturepricesin advance,he
could simplyspecifya processwherebysuchpriceswouldbe determined.38
Such flexiblepricingcan take a numberof different
forms.
The French administrativelaw doctrine of imprevision39 and, to a
lesser degree,the commonlaw doctrinesof frustration
and quasicontractare examplesof such flexiblepricingat the implicitsocial
contractlevel. Alternatively,
price could be adjustedaccordingto
some formula.A cost-of-living
escalatoris the simplestexampleof
THE BELL JOURNAL
436 /.OF ECONOMICS
thatthe arrayof
and, furthermore,
devices(includingpatents)are quite imperfect,
is muchricherand morecomplexthanstandardeconomic
alternatives
institutional
analysessuggest.
36 See National Fire Insurance Co. v. Sullard, 89 N.Y.S. 934: 97AD233(1904)in
Joskow(1973,p. 404)
in customers.
rights
agentsweregivenproperty
whichinsurance
of the
of thisrighthas severelyslowed the adjustment
complainsthatrecognition
methods.
to superiordistribution
insuranceindustry
liability
37 It is quitepossiblethatinstitutions
can provideless flexibility
ofprivatecontract
of an
and can in someinstanceslead to too muchprotection
thanthoseof regulation
in the
mentioned
Privateproperty
rightsin insurancecustomers
obsoletetechnology.
context,
previousfootnote,provideone likelyexample.In a somewhatdifferent
at one pointin
covenantswritten
Dunham(1972,p. 14) notesthatprivaterestrictive
slow
costsat a laterdate whichcan substantially
timeestablisha set of transactions
to a changingworld.
adjustment
forelementsotherthanpriceas well.For a discus38 Flexibility
willbe important
in long-term
and legalviewpoint,
frombotha planning
relationships
sionof flexibility
see Macneil(1975).
thatthe
contracts
39 Friedman
(1951,p. 34) notes:"It is inregardto administrative
developed.Since 1905,Frenchadministrative
ofimprevision
was first
famousdoctrine
contractsin favourof the private
tribunalshave adjustedtermsof administrative
risein costs,would
suchas a substantial
wherea changeofcircumstances,
contractor
mostof
Thishas inspired
to holdhimtothetermsoftheagreement.
makeitinequitable
of thedoctrineof frustration."
therecentdevelopments
thisapproach.Prices could be set in relationto some presumably
exogenousprice,forexample,the spot marketprice.40Or theprice
mightbe set as a function
of grossrevenues.41
Fullerand Braucher
summarizewell the arrayof options
:42
Flexibility
is sometimes
sought. . . byleavingthepricein a supplycontract
to be set
by agreement
fromtimeto time.The agreement
maycontaina generalarbitration
clause. . . or itmaycontaina specificprovision
forarbitration
intheeventofa failure
ofthepartiesto agreeon price.Frequently
no standard
is established
forthearbitrator
otherthantheimpliedone ofgeneralfairness
andprevailing
pricelevels.Atothertimes
theagreement
willincludea formula
thatinterlocks
thepriceto be paidby thebuyer
withthepriceofthesameproduct,
or a relatedproduct,
on somedesignated
market.
At
othertimes,particularly
in agreements
betweencorporations
in ownership
affiliated
or
management,
pricewillbe determined
byactualcostto thesellerplusa percentage
for
profit.
In such"cost plus" contracts
an elaboratedefinition
of "cost" willusuallybe
required,as well as considerablefaithin the processesby whichcost accountants
purport
to allocatecostswheremorethanone productis beingmanufactured
or sold.
Flexiblepricingtechniquesare riskshifting
devices,43
buttheyare
muchmorethanthat.Priceflexibility
preservesthedecisionmaker's
abilityto adjustto changing
conditions.
It providestheopportunity
to
makebettershort-run
allocationdecisionsundertheumbrellaof the
long-term
contract.44
In a complexworld,agents(or contracting
partiesgenerally)
are unableto specifythecharacteristics
oftheproduct
at the formation
stage.45Thus, in designinga contractforan ad40 In Socony-Vacluum,
long-term
contracts
forgasolinefixedthepriceon thebasis
oftheprevailing
spotmarket
price.Industry
members
agreedto a procedure
ofbuying
"excess" gasolinein thespotmarket
in orderto raiseprices,demonstrating
thatsuch
externalprices need not be trulyexogenous. UnitedStates v. Socony-VacuumOil Co.,
310 U.S. 150 (1940). Similarly,
about halfthe wholesalemeat sales are forfuture
deliverywiththepricebeingtheone reported
in the "Yellow Sheet" on thedateof
delivery;
fora discussionofallegedmanipulation
ofYellowSheetpricesbymajormeat
packers,see Kwitny(1974).Fishlow(1974,p. 269)notesthatin Brazil,whereindexing
has been builtintomanylong-term
contracts,
the choiceof an indexhas becomea
politicalissue.
41 In American
centerstenantspay a fixedrentor fiveto six percentof
shopping
the gross,whicheveris larger;Fuller and Braucher(1964, p. 79) note thatsuch
arrangements
havebecomeverycommoninlong-term
realestate
leasesforcommercial
generally.
Such pricingis also commonforfranchising
arrangements
and royalty
payments.
42 FullerandBraucher
(1964,pp.77-78).Fora detaileddiscussionofthevariety
of
see "BusinessPracticesandtheInflexibility
ofLong-Term
flexible
pricing
techniques,
Contracts"(1950).
43 The defense
thatas thegovernment
contracting
literature
suggests
bearsa larger
shareoftherisksofcostoverruns-that
is, as thecontract
typeshifts
fromfixedprice
to cost plusfixedfee-bidderswilldecreasetheirbid price;see Moore(1967,p. 49),
andFeeney,McGlothlin,
is probably
andWolfson
(1964).Whilethefederalgovernment
betterableto beartherisksthandefensecontractors,
itis notobviousthata wiseagent
wouldshiftthe riskfrom,say, a cable televisionfirmto a local community.
44 The importance
attachedto flexibility
is wellillustrated
bybehaviorinthepaper
industry.
According
to Macaulay(1963,p. 60):
The standardcontractused by manufacturers
of paperto sell to magazinepublishers
has a pricingclause whichis probablysufficiently
vagueto makethecontractlegally
unenforceable.
The house counselof one of the largestpaper producerssaid that
intheindustry
is awareofthisbecauseofa leadingNew Yorkcase concerneveryone
butthatno one cares.
ingthe contract,
45 Whiletheargument
in thetextconcernsthe flexibility
to adaptto changesin
the inability
specifications,
to specifyqualityat theformation
stageand subsequent
in monitoring
difficulties
it willalso increasetheattractiveness
ofcost-basedpricing
in
contracts
forlong-term
provisionof a bundleof services.Problemsassociatedwith
determining
and monitoring
qualityare discussedin Section6.
GOLDBERG
/ 437
vanced weapons systemembodyinga numberof advances in the
currentstate of the arts,construction
of a complexnew chemical
plant,46
or a telephonesystemto be operatedover a longperiodof
time,theagentwilldesireflexibility
to adapthis plansto incorporate
newknowledgedevelopedduringtheperformance
ofthecontract(or
developedexogenously)and to adaptalso to possiblechangesin the
principals'preferences.
It would be extremely
difficult
to maintain
such flexibility
witha fixedprice if the desiredchangesentailed
increasedcosts for the providers.47
If the change orderscan be
isolated,thecontractat theformation
stagemightappropriately
call
fora fixedpriceplusa cost-basedadjustment
forchangesin specifications;48if the changesare likelyto be a significant
aspect of the
productbeingprocuredor if assigningcosts to the changesin specificationsis very difficult,
then the agent mightdesire to extend
cost-basedpricingto the entirecontract.
Manyofthetechniquesused in otherflexiblepricingcontracts
are
ill-adaptedto problemsin the regulatory
sector. Cost-of-living
escalatorscan adjustfortherisksentailedin a changing
pricelevelbut
are of no help in adjustingto changesin relativefactorscarcity,
qualitychanges,or productiontechniques.Prices mightbe tied to
spot marketprices,but spot marketsformostregulatedindustries
seldomexist (nor would the likelihoodof theirexistencebe much
enhancedunderalternative
nonregulatory
regimes);even iftheydid
exist,therewouldbe greatdifficulties
in determining
therelevantspot
pricesincecosts oftendependon customercharacteristics
(likelocation),theavailability
offuel,and otherlocalizedfactors.Comparabilitywithbenchmark
producers(government
or privatefirms)offers
someguidance,but,as thelongcontroversy
overthecomparability
of
TVA to privateutilitiesshowed,conclusiveinexpensiveanswersare
notlikelyto be found.
It seemsreasonableto concludethattheagentwoulddesiresome
flexible
inthelong-term
pricingmechanism
forprovisionofa
contract
naturalmonopolyservice.Whilesomeof thetechniquesdiscussedin
the previous paragraphmightbe utilized (e.g., fuel adjustment
clauses),itis quitelikelythattherewillbe a largecost-basedcomponent.In particular,
one formof cost-basedpricing-rateof return
regulation-appears
to be at leasta plausiblechoice.It is notobvious
thatanyoftheotherimperfect
flexiblepricingmechanisms
(including
the special case of prices fixedat the formationstage) will be
superior.49
THE BELL JOURNAL
438 / OF ECONOMICS
46 For constructing
plants,Business Week notes: "Most of the
petrochemical
fromtheold
typeofcontract
cost-plus-fixed-fee
to a negotiated,
has switched
industry
withthelowestbid gottheproject."See "Fluor
bid wherethecontractor
fixed-price
Gambleson a Flock of New Orders,"Business Week, November9, 1974,p. 129.
47 If thechanges
of
led to lowercosts,thefixedfeewoulddeprivethecustomers
to lowerqualitystanthesavings;it wouldalso greatlycurtailtheagent'sincentives
thequality
withlowerpricesto offset
wouldnotbe rewarded
dardssincehisprincipals
reduction.
48 We muststressthatin actual commercial
relationships,
ongoingcontractual
of thewordingof theformalcontract;see
oftenwillbe maderegardless
adjustments
Macaulay(1963).
49 The problems
in
havebeendiscussedextensively
arising
fromcost-basedpricing
see Scherer(1964).See also thediscussioninSection
literature;
thedefensecontracting
6.
* The discussionofpricingin theprevioussectionassumedthatonly
5. Protecting the
a singleprice was to be charged.Since most observedlong-termconsumers' rightto
contractsdeal witha singlecustomer,it is not necessaryin those
be served
contextsto discussrulesfordesigning
a pricestructure.
However,in
collectivecontractsthis is no longertrue and, consequently,the
of theagent'staskis increased.He mustnow determine
complexity
an initialratestructure
thestructure
and rulesforadjusting
overtime;
the conditionsunderwhichserviceto
thisincludesrulesgoverning
specificindividualsor classes of customerscan be terminated
and
rulesgoverning
thepricesofferedto new customers.
Whilefor much economicactivitycustomerprotectionagainst
in some
termination
(or a suddenprice increase)is not important,
instancesit wouldbe veryvaluable.A franchise
in whichthe
contract
veryexistenceof one of the partiesis threatened
by termination
providesone privatesectorexample.50
Protection
of the rightto be
servedis generallyof greaterimportin the regulatedsector.51The
betweenitsex ante and ex post
customerwillfinda greatdistinction
demand.Beforelocatingitsplantat a particular
site,a firmwillhave a
numberof optionsand, therefore,
its demandfor,say, rail services
willbe moreelasticthanaftertheplanthas beenbuilt.BusinessWeek
willrely
providesa graphicexampleoftheextentto whichcustomers
on thecontinuance
oftherelationship
andofthecoststhatwillariseif
:52
thatrelianceis misplaced
ofevena shorthiatusin PennCentralserviceis so greatthatauto,steel
Themagnitude
and chemicalindustries,
amongotherbusinesseslocatedalongthe 19,000mi.of line,
service.VictorLong, directorof
say thereis no way even to plan foralternative
of
forGeneralMotorssays,"You can'tmakecontingency
logistics
plansforsomething
thisscope." Longsays42 GM plantsareservedexclusively
byPennCentral,andsome
ofthemwouldbe affected
within
24 hours.FordMotorCo., with29 plantsexclusively
on thePC, says,"Thereis no waywe couldsustainouroperation."Dupontadds: "A
shutdown
wouldmeaninsurmountable
problemsforeveryshipper."
of
Thereare threerootsforthecustomers'demandforprotection
the
the rightto be served. First,once the relationship
has begun,
and willbe
supplierwillbe isolatedto somedegreefromcompetition
in a positionto "hold up" theconsumer.A simpleexamplewouldbe
theautomobilemechanicwho agreesto fixa car, takesit apart,and
thensays he willput it togetheragain at threetimesthe originally
agreedupon price.53Generally,afterthe consumerhas enteredinto
therelationship
withtheproducer,he willfindhimselfvulnerableto
theproducerwillbe in a
priceincreasesor thethreatof termination;
in an attemptto capturethe "ex post
positionto pricediscriminate
54 In additionto protection
frombeingheld up,
consumersurplus."
10 See
Macaulay(1970)and Kessler(1957).
The factthatthe
5' The rights
to serveand be servedare nottotallyindependent.
increasesthe
customer's
optionsaregenerally
restricted
bytheregulatory
arrangement
importance
oftherightto be served.Protection
oftherightto be servedin theformof
thecommoncarrierrulelongprecedesthe appearanceof the moderninstitutions
of
regulation.
52 "PennCentral
PutsOffDoomsday,"BusinessWeek,February17, 1975,p. 30.
53 The consumer
wouldbe protectedunderone or morecommonlaw doctrines
Commer(e.g., preexisting
dutyor unconscionability)
or Section2-209oftheUniform
cial Code. These representa responseby agentsat a different
level (judicialand
legislative)
to the holdup problem.
afterhe has madea
54 Sincetheconsumer's
demandcurvecan lookverydifferent
pricediscriminacommitment
tothelong-term
contract,
itis important
whendiscussing
GOLDBERG /439
the customerswill desireprotectionfromarbitrary
and capricious
treatment.
Finally,theywillwantto deal withtheproblemof"honest
mistakes."The customerswantto makeinvestment
decisionson the
basis of reasonablepriceexpectationsbut the producerfindsthata
particular
serviceis no longer(or neverwas) profitable;
thecustomer
therefore
wouldlikesomeprotection
forhisreasonablepriceexpectationsagainstthegoodfaithdecisionsofthesupplierto terminate
or to
increaseprices."5
It shouldbe clearthatprotection
of therightto be servedis not
theonlymechanism
whichconsumerscan use to achievetheirgoal.
maintainmultiplesuppliers,mainTheycould engagein stockpiling,
tainstandbycapacity,insure,or perhapseven resortto verticalintegration.Determination
of the appropriate
mixof theseimperfect
alternatives
is obviouslya complexproblem.It is reasonableto suggest,
however,thatprotection
of the rightto be servedwouldfrequently
play a prominent
rolein themixeschosenby agentsforcontractsto
servethe naturalmonopolyindustries.
Protection
oftherightto be serveddoes notcomecostlessly.The
agent must thereforebalance the benefitsof protecting
the right
againstthecosts suchprotection
entails.The problemconceptually
is
similarto thatof protecting
therightto servediscussedin Section3.
Producersmightbe reluctant
to initiateparticular
servicesiftheydo
if futurecirnot have the freedomto adjustprices (or terminate)
cumstanceswarrant.This problemis in partmitigated
by regulatory
policieswhichgenerallyrequiretheutility
to extendservicesand by
compensationschemeswhich base utilityearningson the overall
noton individualservices-i.e., rateof return
operationsof thefirm,
regulation.Giventheseinstitutional
constraints
on the supplier,the
morelikelyeffectwillbe thatservicewillbe overextended
and that
particular
serviceswillbe keptalivetoo long.56If thefirmis to make
a reasonableprofit,
the cost of providing
servicesmust
unprofitable
be coveredby somesubsetofthecustomers;in effect,
will
customers
in theformofhigherprices.In addition,if
pay an insurancepremium
pricesare preventedfromadjustingto short-run
changesin supply
and demandconditions,therewillbe persistent
short-term
resource
misallocation.57
THE BELL, JOURNAL
440 / OF ECONOMICS
generbetweenex ante andex post demandcurves.Thisdistinction
tionto distinguish
orientation.
froma discretetransaction
allyappearstobe ignoredinanalysesstemming
The producercan increasehis revenueby a moreindirectmeansby usingthe
of dealers,
to disciplinetroublemakers-forexampleorganizers
threatof termination
of unionorganizers.
Thisis, of course,analogousto thefiring
tenants,or customers.
and do notperceivethe risks?Shouldwe
5 Whatifconsumersare uninformed
to such risksbecause theirignoranceshields
encouragethemto expose themselves
themfromthe undesirableresultsdiscussedin the text?We can stillsuggestan
Failureto adoptprotecprotection.
forjustifying
argument
efficiency-based
alternative
losses in the
futureriskscan lead to significant
tiontodayagainstthe unperceived
whichwouldmakesociety
lossescan cause socialdislocations
andthesefuture
future,
measurestoday.Thisnotion
as a wholeworseoffforhavingfailedto adoptprotective
is analogousto Calabresi's"secondarycosts" of accidents;see Calabresi(1970,pp.
therisksand
ineffect,
delegateto theagentthetasksofevaluating
39-67).Consumers,
of alternative
responsesto the risks.
the efficacy
of determining
theseforcesby
56 It shouldbe pointed
can to someextentoffset
outthattheutility
practices.
qualityand by usingselectivemarketing
degrading
57 The vulnerability
bytheutility
to arbitrary
treatment
customer
oftheindividual
of the individual'srightto be served
proceduralprotection
suggeststhatsubstantial
extensiveand expensive
wouldbe desirable.However,if the firmmustgo through
We do not intendto considerherehow the agentshouldbalance
of consumerrelianceagainstthe costs of possiblehigher
protection
averageprices and staticmisallocation.The pointwe do want to
stressis thatanalysesin the discretetransaction
tradition
tendto
thestaticmisallocation
focusonlyon thesecost elements-primarily
problems-andignorethepossibility
thatsome of thesecosts might
conditions
well be worthbearing.Modelingwhichderivesefficiency
withtheimplicit
thatthereshouldbe no protection
ofthe
assumption
rightto be servedwill,exceptbyaccident,givewrongand misleading
answers.
* If,as theabove argument
suggests,contracts
fortheprovisionofa
naturalmonopolyservice will be long-term
agreementswithcost
thentheagent'staskis notdoneonce thecontracthas
based pricing,
been let.58As Posnernotes,a whole new set of issues arises:59
6. Administering
the contract
ofprofit
Whatourdiscussionofthepernicious
side effects
regulation
crucially
implies
is thatif an attemptis madeto limita company'sprofits
thegovernment
mustalso
offirm
behaviorthatcouldotherwise
be leftto thefree
concernitselfwithdimensions
market,
suchas theefficiency
withwhichthefirm
employscapitalandotherresources,
therateanddirection
and ...
ofitsinventive
activity,
itsexpansionintoothermarkets,
thestructure
ofits prices.These are areas in whicha naturalmonopolist
leftto itself
might
be expectedat leastto approximate
satisfactory
performance.
Once itsprofits
are
and
constrained-even
partially-the
monopolist's
incentives
to economically
efficient
controlsof comprogressive
performance
are distorted,
and muchbroaderregulatory
panyactivitybecomenecessary.
He is rightin observingthatonce we beginto attemptto limitthe
firm's
profits,
we havetakenthefirst
stepdowntheslipperyslopeand
mustthenengagein a lot of otherdetailedoversight.He is wrong,
however,in suggesting
thatthe roots of our difficulties
lie in the
institutions
of regulation.
The problemsare intrinsic
to the service,
not to the act of regulation
itself.
That is, if the regulatory
relationship
were replacedby a private
theproblemsfacedby theprivateagentwoulddiffer
contract,
mainly
in degreeratherthanin kindfromthosethatplagueregulators
and
providea fieldday fortheircritics.Indeed,even in a rathersimple
privatesectorcontractlike a university
food servicecontract60
one
horrors.
can observeon a lesserscale thewholepanoplyofregulatory
it mightfindit cheaperto continueservingthem,
customers
to terminate
proceedings
to thegroupas a whole
are behavingin a mannerdetrimental
evenifthosecustomers
to workoutexamplesin
(forexample,notpayingtheirbills).It shouldnotbe difficult
behavior.Starr
antigroup
whichthehighpriceof due processwilllead to substantial
of tenantsin public
(1971),forexample,arguesthatincreaseddue processprotection
to deal with"problem"
forthe authorities
difficult
housinghas made it extremely
of publichousing.
cause of thedeterioration
tenants;this,he suggests,is a primary
58 Sincewe are usingthebidding
there
forthemarketnotiononlymetaphorically,
wereactuallybeingput
thatariseifsucha contract
is no needto considertheproblems
offranchise
biddingas a
thepossibility
out to bid. If,however,we wereconsidering
For an exampleof
wouldbe appropriate.
sucha comparision
forregulation,
substitute
(1976)and Goldberg(1976c).
thatarisein thisregard,see Williamson
thedifficulties
59Posner(1969,pp. 605-606).
thecontractis nota
sectorand therefore
60 The university
is in thenot-for-profit
The bulkofthecontract
important.
butthisis notterribly
affair,
purelyprivatemarket
Splurge,"
does deal withtheprivatesector;see "America'sEating-Out
foodindustry
because
primarily
BusinessWeek,October27, 1975,p. 45. We focuson theuniversity
sucha contract.
and administering
experiencein negotiating
we have had first-hand
GOLDBERG / 441
Such contractstypically
lastforthreeyearswiththepriceforthe
last twoyearsto be determined
on thebasis ofexpectedcostsplusa
specifiedrate of returnon sales. The university,
like the regulator,
mustdetermine
whichcosts are allowable;it mustfurther
decideon
how detailedits monitoring
of thefirmshouldbe, and on how much
discretionthe firm'smanagement
shouldhave in makingdecisions
thatwillaffectcosts.61The university
mustalso determine
whatitwill
considerto be a "reasonableprofit,"and it mustdecide how much
it shouldexertto ascertainthefirm'strueprofits.
effort
In particular,
it willhave to monitorintra-firm
transfers
betweenthe fiscalentity
underitsjurisdiction
and thefirm'scentralheadquarters
(forvarious
managerialservices)or supplierdivisions.The problemis analogous
to thedifficulties
encountered
by a stateregulatory
agencyanalyzing
the cost allocationsmadeby AT & T forlongdistancecalls, or the
pricesforequipmentchargedoperating
companiesby WesternElec-
tric.62
Qualityof serviceraises a numberof problems.The agentmust
devisecriteriaand a processforchanging
thequalityof service(and
perhapstheprice)ifexperienceindicatesthattheinitialqualitylevel
chosen was inadequate(or too high).The qualitycriteriamustbe
flexibleenoughso thatthemanagement
is notprecludedfromtaking
advantageof bargains.(That is, the contractshouldnotrequirethat
onlyBrandX coffeebe used or thatporkchopsbe servedon Monday
nights.)Yet thestandardmustbe objectiveenoughso thattheagent
can conveythe standardsto the providerand monitorcompliance.
The agentwillfindthatthereare substantial
problemsin monitoringcompliance.To perform
thetasksatisfactorily,
he mustimmerse
himselfin trivia.Is theresufficient
choice of breakfastcereals?Do
theyrunout of themainentreestoo often?Are theyusing"choice"
meatin thestew?The agentwillhave to investigate
consumercomplaintsregarding
thegeneralqualityof service.He willfindthatit is
too expensiveto monitoreverything
effectively
and, consequently,
some noncompliancewill get by, yet it is also likelythat a not
insignificant
amountof resourceswillgo towardmonitoring.
It is not
too fancifulto suggestthatthe ratioof timespentquibblingover
trifles
to industry
value added is higherin the contractfood service
thaninthetelephoneindustry
industry
or otherregulated
industries.63
The foodserviceexamplemightnotadequatelycapturethecomplexityof theproblem.Consider,therefore,
a businessfirmpurchasing privateline servicesfroma telephonecompany.64
How is the
buyerto monitorperformance?
The methodsand criteriait adopts
would probablynot differmuchfromthose developedby the regthequalityof service;these
are decisionsconcerning
importance
Of particular
willbe discussedbelow.
62 One difference
has
contextis therelativeease theuniversity
fromtheregulatory
to bidagainare costly,
a contract
and putting
Termination
thecontract.
in terminating
but theyare optionswhichare availableand, fromtimeto time,are used. The
theserviceitself
and providing
integrating
university
also has theoptionof vertically
whichmany,in fact,do; it also has theoptionof morecompleteverticaldisintegraon themarket-anoptionwhichis also
and relying
tion-havingno collectivecontract
taken.
sometimes
agenciesplace on trivia,see MacAvoy
63 For criticism
oftheemphasisregulatory
(1971),Lewis (1967),and Posner(1969).
64 See also Williamson
(1976) fora discussionof some of the problemsin the
contextof a cable televisioncontract.
61
THE BELL JOURNAL
442 / OF ECONOMICS
betweenthetwo cases is the
difference
ulators.The one substantial
task. He can establishperagent's
private
this
of
simplicity
relative
ofthefirm.While
members
of
the
terms
of
in
goals
criteria
formance
thesegoals are not necessarilyso mutuallyconsistentas traditional
models assume, they are likelyto be far more
profitmaximizing
at
and ascertainablethanthe goals of the community
homogeneous
(or
consumerpreferences
ofdetermining
large.Hence,thedifficulties
in the
oughtto be) are greatlydiminished
whatconsumerpreferences
and clearer
preferences
privatelineexample.The morehomogeneous
mightlead to thechoice
feedbacksignalsof theprivatearrangement
butat
setofmonitoring
techniques,
(and moreeffective)
ofa different
thetasksof thepublicand privateagent
least in theirbroadoutlinesare the same.65
both in its
Capitalposes a numberof problemsfor regulators,
ofcapitaldecisions(to controlthe
and inthemonitoring
measurement
tendencyto expand the rate base). The same sortof issues arise,
forthe
contracts
long-term
form,within
albeitina somewhatdifferent
provisionof servicesin whichfixed,specializedcapitalmustbe used
If
(e.g., thefood servicecontract,or a cable televisionagreement).
thelifeof thecapitaldoes notcoincidewiththelifeof thecontract,
it will
terminated)
thenwhenthe contractexpires(or is prematurely
the capitalis
the capitalconsumption-if
be necessaryto determine
or theiragent-or the"fairmarketvalue" of
ownedby thecustomers
the survivingcapital-if it is owned by the providerbut must(or
oughtto)66be sold back to theotherpartyor to thenewprovider.In
eithercase thetaskcan be a complexand expensiveone to perform.
is variable(dependingon thelevel
If therateof capitalconsumption
thenthe rulesthatthe agentuses
effort)
of outputand maintenance
therelawill,in effect,determine
capitalconsumption
to determine
alterativepriceof capital;therulescould lead to factorproportion
effect.67
tionsnot unlikethe Averch-Johnson
65 For a description
qualityof telephone
of California'ssystemfor monitoring
standardsincludea
service,see Public UtilitiesCommission(1972). Performance
rateshouldbe at least98
example,thecall completion
criteria-for
oftechnical
number
complicance.Whilethereoftenare
percent(pp. 13-14)-and methodsformeasuring
and
whichmakethecollectiveestablishment
economiesof cost spreading
substantial
desirable,thisdoes notmeanthattheagencyshould(or
ofqualitystandards
monitoring
performance
forsatisfactory
all qualitydecisions.Indeed,one criterion
does) centralize
is a rateof fewerthan6.5 customertroublereportsper 100stationsper month(pp.
(forexample,the
in manydimensions
clearlyare discernible
12-13).Qualityvariations
be desirableto leave
choicebetweenprivateand partylines)and it wouldgenerally
such decisionsto the customer.The extentto whichqualitydecisionsshouldbe
issue(see note16)which,while
jurisdiction"
delegatedbytheagentis an "appropriate
is beyondthe scope of thispaper.
fascinating,
66 The contract
couldactuallyrequiresuchresaleat "fair"pricesor thefactthat
could makeresale
the capitalis worthso littleto the holderwithoutthe franchise
(1976)hasa detaileddiscussionof
Williamson
notinevitable.
likely,although
extremely
of
whichincludesa description
contract
ofcapitalin thecabletelevision
thetreatment
fromthe providerback to the city.See also
equipment
the processfortransferring
in automobile
of termination
compensation
Macaulay's(1966,pp. 90-91)description
contracts.
dealershipfranchise
and capitalconsump67 In thefoodservicethecapitalis ownedbytheuniversity
ofgrossrevenueto coverrentforland,
tionis pricedby payinga feeas a percentage
to an inputof
ofthegrosscompensation
etc. Percentage
tables,dishwashers,
buildings,
(whichis commonin a numberof othercontextssuchas shoppingcenter
production
lead to overuseof thatinput-at least accordingto traditional
leases) willtypically
andthat
Whenitis realizedthatusingthepricesystemis not.costless
welfarecriteria.
GOLDBERG
/ 443
decisions
Whatshouldbe the agent'srole in capitalexpenditure
thatarise duringthe lifeof the contract?To whatextentshouldhe
in evaluatingcapitalexpenditures?
"duplicate"the supplier'sefforts
Extensivesupervisionis costlyboth in termsof the out-of-pocket
ofthe
and in termsofthesacrificeofthebenefits
costsof monitoring
provider'spresumedexpertise,a sacrificewhichcan be verygreatif
the knowledgegainedfromoperatingprogramsis a usefulinputin
capitaldecisions.On theotherhand,givingtheprovidera relatively
capitalexpen(or undertake)
freereinwillinducehimto recommend
specified,
ditureswhich,ifthecapital"pricing"rulesare improperly
can lead to an excess of capital.Perhapsa moreseriousproblemis
capitaldecisionsso as to
theproducer'sincentiveto tryto influence
enhancehis relativeadvantagein futurebidding.This can take the
equipmentwhichtakesadvantageof idiosynformof recommending
to develop
firm.
Thereis, indeed,an incentive
craciesoftheproviding
one's
such idiosyncracies(similarto the incentiveto differentiate
product)so as to increasethe relativedisadvantageof new bidders.
The precedingdiscussionshouldnot be takento mean thatthe
in
problemsraisedare insoluble.Theyare, indeed,resolvedregularly
parties.Whether
to thecontracting
satisfactory
a mannerapparently
theyare solvedas well as theycould be in termsof thecontracting
parties'interestsand whetherthe solutionsare also in the best inquestions.
terestof thosenotpartyto thecontractare moredifficult
agreedto willbe
The pointis, however,thatthe solutionultimately
welfareeconomicsand,further,
oftraditional
bythecriteria
imperfect
willbe similarto thosethatariseunderregulathattheimperfections
flexiblepricingcontractswithcost-based,profittion. Long-term,
discouragehard
efficiency,
limitation
featureswilldiscourageinternal
withlaborand othersuppliers,encouragegoldplating,and
bargaining
Thatis, theproviderwillhave
encourageexcessivecapitalformation.
firm.Likewise,theagent
to act verymuchlikea regulated
incentives
analyzingthe
willhave incentivesto act verymuchlike a regulator,
themeasuredprofits
whether
determining
oftheprovider,
costfigures
monitoring
qualityand
laidoutintheinitialcontract,
meetthecriteria
capitaldecisions,and so forth.
7. Concluding
remarks
THE BELL JOURNAL
444 / OF ECONOMICS
to reiteratethatwe are not makinga case for
* It is important
be looked upon as
This essay mightmoreappropriately
regulation.
"the case againstthecase againstregulation."Manyoftheproblems
thatarise in regulatedindustrieswould arise even if the industries
of a regulatory
agency(althoughthe
werenotunderthejurisdiction
someof
oftheproblemsneednotbe thesame).68Further,
magnitude
to percentageof the gross pricing(see the
thereare otherreasonsfor resorting
in Section4), thenitis no longerclearthattherereallyis
pricing
discussionofflexible
a
notnecessarily
alteration,
"overuse." Whatwe have is merelya factorproportion
bias.
factorproportion
for
contracts
involvedinfranchise
68 For a suggestive
discussionofthedifficulties
to
provisionof cable television,see Williamson(1976). Of course,the alternative
need not be a publiclylet franchisecontract;it could simplybe private
regulation
including,
ofthepubliclaw ofcontract
madeunderthejurisdiction
contracts
individual
laws. Whileanalysisof theimpactof thesebodiesof law on an
perhaps,theantitrust
naturalmonopolysectoris well beyondthe scope of thisessay,thereis
unregulated
has notingeneralbeen
or at leastcaution.The law ofcontracts
reasonforpessimism,
its
very successfulin adaptingto relationalexchangepatterns;it has maintained
problemsperceivedby economistsare largelyillusory;
theregulatory
outcomesagainstirrelevant
theyare theresultof stackingregulatory
comstandardsgeneratedby modelswhichsuppressthe contractual
in the so-callednaturalmonopolysector.69
plexitiesinherent
contractsapproachprovidesa very different
The administered
The "justification"
institutions.
regulatory
forexamining
perspective
is seen to restnoton narrownaturalmonopoly(declinof regulation
averagecosts) grounds;ratherit restson thelong-term
inglong-run
s stressedhere. Thus, the observedemphasisby
relationalmatter
whichappears
agencieson protectionfromcompetition,
regulatory
has a plausibleexquiteanomalouswithinthe standardframework,
planationin thisbroadercontext.
Perhaps of greater importance,the administeredcontracts
in regulatory
opensup newareasofsearchforinnovations
framework
Currentresearchtypicallybeginswithan optimization
institutions.
condiwhichwillsatisfystaticefficiency
modeland seeksinnovations
the
and
pricing
load
of the model;peak
tionswithintheframework
apOur
this
genre.
of
optimalfairrateof returnprovideexamples
mainfor
on
mechanisms
emphasis
greater
proachplaces a relatively
relationships.
long-term
taining,adjusting,and, perhaps,terminating
heretofore
innovation
institutional
for
sources
it
suggests
Further,
on
emphasis
The
regulation.
studying
by
economists
ignored
largely
to serveand be servedraisesthenaturalquestionofhow,ifat
rights
suggeststhe
all, thoserightsshouldbe protected.Such a formulation
formsresponsiveto
relevanceof analyticaltools and institutional
such questionsas: how shouldX's rightto breatheclean air be
activitywhichpollutesthatair?Thus,
fromY's productive
protected
as
we are led to considerthe efficacyof such legal instruments
A
rights.70
damagerules,and otherformsof protecting
injunctions,
second source of innovationis observationof the behaviorof pridesign,police,and
parties.How do businessmen
vatelycontracting
Can any of the techniquesthat
relationships?
adjusttheirlong-term
to the
transferred
have evolved in the privatesectorbe fruitfully
publicsector?
of thisessay go beyondalteringour perspective
The implications
of
on regulation.
Economictheorygenerallyignoresthe complexity
assumingthatmostexchange
by implicitly
arrangements
contractual
form.Indeed, some of the
takes place in the discretetransaction
of recentyears (forexample,time-dated
theoreticalbreakthroughs
markets)have takentheformofforcing
and contingent
commodities
mold.We
overtimeintoa discretetransaction
complexrelationships
(forexample,to regulatory
jurisdiction
in largepartbyrelinquishing
integrity
doctrinal
"generalrulesadequateforregulatagencies)so thatit has becomea law ofleftovers,
enoughto
enoughor numerous
whichare eithernotcomplicated
ingthosetransactions
ofseparatebodiesofrules"(Summers,1969,p. 567).
thedevelopment
havestimulated
mare's
law presentsa veritable
(1965).Antitrust
See also Macneil(1974)and Friedman
of
termination
contracts,
naturalmonopolysector:multiyear
nestfora deregulated
local tele(e.g., notpermitting
refusalto provideservicesto competitors
customers,
issueswillbring
and similar
network),
to tiein witha largertelephone
phonecompanies
withthelaw (although
manysuch
intoconstantconflict
of theproducers
theactivities
activitieswouldlikelybe desirable).Further,it is quite probablethatthejudicial
a minidecree,in effectestablishing
remedywould take the formof a regulatory
agency;see Posner(1970,pp. 386, 388) and Timberg(1954).
regulatory
69 See thediscussion
analysisin Demsetz(1969).
institutional
of comparative
70 See generally
Coase (1960)and CalabresiandMelamed(1972);foran analysisof
of the rightto be servedin thisspirit,see Goldberg(1976b).
protection
GOLDBERG
/ 445
suggestiveto encourage
hope thatthis essay has been sufficiently
ofopeningup theblack
to exploreseriouslytheimplications
theorists
box of contract.
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PUBLIC
UTILITIES
COMMISSION
OF THE STATE
OF CALIFORNIA.
"Investigation
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