Repeated auctions of incentive contracts, investment and bidding parity : with an application to takeovers

Abstract

This paper considers a two-period model of repeated franchise bidding or second sourcing. A regulator contracts with a single firm in each period, presumably because of increasing returns to scale. The incumbent firm invests in the first period. The investment may be transferable to a second source or not; and may be monetary or in human capital. Each firm has private information about its intrinsic efficiency, and, if it is selected to produce. about the cost-reducing effort it exerts and the investment it makes. The regulator, however, observes the firm's realized cost at the end of the period (the cost includes monetary investments and may be random). In the second period the incumbent firm can be replaced by an entrant. The regulator commits to an optimal breakout rule. The paper generalizes an earlier result that the optimal policy is to regulate through contracts linear in cost overruns. It also derives conclusions concerning the intertemporal evolution of incentive schemes. Mainly, it puts emphasis on the issue of bidding parity. It shows that three basic effects guide the optimal bias in the second-period auctioning process and determines whether the incumbent should be favored depending on the nature of investments. The outcome of the analysis is a relatively pessimistic assessment of the desirability of second sourcing when sizeable investments are at stake. Last we reinterpret the second source as a raider, and the breakout as a takeover. We discuss the desirability of defensive tactics, and obtain some relationships between the size of managerial stock options, the amount of defensive tactics, the firm's performance and the probability of a takeover.