Auctions could improve private highway franchises

Transportation agencies in the USA are franchising highway construction and operation to private firms in order to reduce costs and attract private capital. The right to build and operate the highways are auctioned to bidders who recoup their investment by collecting tolls. But the two private highway franchises currently operating in the United States have encountered serious problems.

Researchers at Yale University and the University of Chile suggest a variation on the classic Demsetz auction, which awards the franchise to the bidder who asks for the lowest toll.

Under the new proposal, firms would compete on the basis of the minimum toll revenue (in present value terms) requested by bidders – a Present Value of Revenues (PVR) auction.

In a PVR auction:

Regulators set a maximum toll, and the firm that wins the contract is the one that bids the least present value of toll revenue over the life of the contract.

The franchise ends when the present value of toll revenue equals the franchise holder's bid.

Toll revenue is discounted at a predetermined rate specified in the contract – which should be a good estimate of the rate of interest the franchise holders will pay on construction loans.

This modified Demsetz auction has a number of advantages. For example,

It reduces risk and thus lowers the return required by bidders.

It reduces the need for guarantees and the scope for future renegotiations.

In addition, the transit authority can adjust the tolls in response to changed conditions without harming the franchise holder.

Moreover, the franchise is flexible because it can incorporate a buyout option that leaves both parties satisfied, so that widening the road itself or allowing free competitors to widen the road in response to increased traffic is not an issue.

Source: Eduardo Engel, Ronald Fischer and Alexander Galetovic, A
New Approach to Private Roads, Regulation, Fall 2003, Cato Institute.

For text http://www.cato.org/pubs/regulation/regv25n3/v25n3-6.pdf
For more on Highway Privatization http://www.ncpa.org/iss/pri/

FMF Policy Bulletin\22 January 2003