Optimal Pricing of Public Franchises With Imperfectly Correlated Demand Shocks
The article "Optimal Pricing of Public Franchises with Imperfectly Correlated Demand Shocks" published in the Journal of Economics and Management Strategy analyses how governments should set prices for the rights to operate public franchises. These are contracts that grant private firms exclusive rights to run existing government-owned facilities, such as public transport or water distribution networks. The firm (the franchisee) is paid through user charges and takes on the commercial risk, but is not typically required to make large investments. In return for this monopoly power, the franchisee makes payments to the government.
The key question the research addresses is how the awarding government body can optimally price these rights when it doesn't have perfect information about consumer demand. Specifically, in our model the franchisee is assumed to know more about consumer preferences affected by unpredictable factors like fuel price fluctuations or weather conditions. The government's goal is to balance two objectives: collecting revenue and ensuring consumer welfare.
What are the main findings?
The paper finds that the optimal pricing strategy in this dynamic and uncertain environment requires a combination of both fixed and time-variable payments between the government and the franchisee.
The Fixed Fee is thepart of the payment that depends on the firm's initial expected profitability. The optimal fixed fee is higher for firms that are expected to be more profitable and also increases with greater uncertainty about future demand. This fee accounts for the persistent nature of the firm's initial revenue potential and helps the government save on future information costs.
The Time-Variable Transfer is the component that adjusts over the life of the contract based on how demand actually evolves. An interesting and somehow counterintuitive result is that theoptimal variable transfer can be negative. This means the government might sometimes need to subsidizerather than charging the franchisee.
What are the implications for policy makers?
The paper shows that optimally managing public franchises under uncertainty requires a flexible pricing system that goes beyond simple fixed fees, allowing for adjustments (including potential payments to the firm) to align incentives and balance public revenue with consumer welfare over time. This optimal mix is highly sensitive to the franchisee's characteristics, the level of demand uncertainty, the actual observed demand, and how much the government values public funds relative to consumer welfare.
In particular, policymakers should rely more heavily on public fees during periods of high uncertainty, while remaining open to subsidizing the firm if demand exceeds expectations during the concession period. This recommendation is especially relevant in contexts where franchise fees are typically rigid and unresponsive, even in the face of significant demand volatility.
