Least-Present-Value-Of-Revenue Auctions and Highway Franchising

Abstract

In recent years several countries have started massive highway franchising programs auctioned to private firms. In these auctions, the regulator typically sets the franchise term and firms bid on tolls, or, alternatively, the regulator sets tolls and the winner is the firm that asks for the shortest franchise term. In this paper we argue that many of the problems that highway franchises have encountered are due to the fact that the franchise term cannot adjust to demand realizations. We propose a new auction mechanism where the firm that bids the least present value of revenue from tolls (LPVR) wins the franchise. With this scheme, the franchise length adjusts endogenously to demand realizations. Assuming that the regulator is not allowed to make transfers to the franchise holder that firms are unable to diversify risk completely due to agency problems auctions are optimal, even when the regulator does not know firms' construction costs. Furthermore, for demand uncertainty and risk aversion parameters typical of developing countries, welfare gains associated with substituting a LPVR auction for a fixed-term auction are large (e.g. one-third of the cost of the highway).