The Economics of Contracts: Theories and Applications

By Eric Brousseau; Jean-Michel Glachant | Go to book overview

NOTES

We would like to thank Ioannis Kessides and David Newbery for their persistent questioning and Richard Green for helpful comments. All remaining errors are naturally our own.

1
This section draws heavily on Spiller (1996).
2
Specific or sunk investments are those, once undertaken, whose value in alternative uses is substantially below their investment cost.
3
See, among others; Goldberg (1976); Williamson (1988b); Barzel (1989); North (1990); Levy and Spiller (1993, 1994).
4
Observe that the source of financing does not change this computation. For example, if the company is completely leveraged, a price below average cost will bring the company to bankruptcy, eliminating the part of the debt associated with the sunk investments. Only the part of the debt that is associated with the value of the non-sunk investments would be able to be subsequently serviced.
5
Observe that this incentive exists both for public and private companies. (See Spiller and Savedoff 2000.)
6
The company will be willing to continue operating because its return from operating will exceed its return from shutting down and deploying its assets elsewhere. On the other hand, the firm will have very little incentive to invest new capital as it will not be able to obtain a return. While it is feasible to conceive loan financing for new investments, as non-repayment would bring the company to bankruptcy, that will not however be the case. Bankruptcy does not mean that the company shuts down. Since the assets are specific, bankruptcy implies a change of ownership from stock holders to creditors. Now creditors' incentives to operate will be the same as the firm, and they would be willing to operate even if quasi-rents are expropriated. Thus, loan financing will not be feasible either.
7
Consider, for example, the case of Montevideo's Gas Company (MGC). Throughout the 1950s and 1960s the MGC, owned and operated by a British company, was denied price increases. Eventually, during the rapid inflation of
the 1960s it went bankrupt and was taken over by the government. Compare this example to the expropriation by the Perón administration of ITT's majority holdings in the Unión Telefónica del Rio de la Plata (UTRP), (UTRP was the main provider of telephones in the Buenos Aires region). In 1946 the Argentinean government paid US$95 million for ITT's holdings, or US$623 million in 1992 prices. Given UTRP's 457,800 lines, it translates at US$1,360 per line in 1992 prices (deflator: capital equipment producer prices). Given that in today's prices, the marginal cost of a line in a large metropolitan city is approximately US$650, the price paid by the Perón administration does not seem unusually low. See Hill and Abdala (1996).
8
See, Goldberg (1976) for one of the first treatments of this problem. See also Williamson (1976).
9
Indeed, the Colombian regulation of value added networks specifically stipulates that the government cannot set their prices, nor that there are any exclusivity provisions. Thus, regulation here means total lack of governmental discretion.
10
On this, see more below.
11
Williamson's basic contracting schema applies here. See Williamson (1995).
12
An alternative way of reducing the specificity of the firm's investment is by customers undertaking the financing of the sunk assets.
13
In this sense it is not surprising that private telecommunications operators have rushed to develop cellular rather than fixed-link networks in Eastern European countries. While cellular has a higher long-run cost than fixed link, and on some quality dimensions is also an inferior product, the magnitude of investment in specific assets is much smaller than in fixed-link networks. Furthermore, a large portion of the specific investments in cellular telephony is undertaken by the customers themselves (who purchase the handsets).
14
The privatization of Argentina's telecommunications companies is particularly illuminating. Prior to the privatization, telephone prices were raised well beyond international levels. It is not surprising that, following the privatization, the government reneged on aspects of the license such as price indexation. The initial high prices, though, allowed the companies to remain profitable, even following the government's deviation from the license provisions. See Levy and Spiller (1993).
15
The concept of regulation as a design problem was first introduced in Levy and Spiller (1993). Here we use the terminology subsequently developed in Levy and Spiller (1994).
16
Williamson would call such constraints on regulatory decision-making “contractual governance institutions. ” (See Williamson 1985, p. 35.)
17
Commenting on the interaction among technology (institutions), governance, and price (regulatory detail) Williamson (1985, p. 36) says, “[i]n as much as price and governance are linked, parties to a contract should not expect to have their cake (low price) and eat it too (no safeguard). ” In other words, there is no “free institutional lunch. ”
18
This section draws heavily on Levy and Spiller (1994).
19
For analysis of the role of separation of powers in diminishing the discretion of the executive, see Gely and Spiller (1990) and McCubbins, Noll and Weingast (1987, 1989), and the references therein.

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