Contestability, Complementary Inputs and Contracting: The Case of Harbour Towage

It has been argued that competitive tendering for contracts can be used to overcome problems of natural monopoly and to make markets 'contestable'. The recent Productivity Commission (2002) report into harbour towage in Australia noted the potential benefits of competition for contracts. Using the example of harbour towage, we investigate these claims when competitive tendering involves one segment of a vertical production chain. We show that direct customer contracting will not result in a perfectly contestable outcome if there is a complementary input provider with market power. We consider whether this situation improves when customers delegate the contracting process. Delegation only improves the outcome from the customers' perspective if the authority is able to receive side payments from the towage operators. Such side payments a priori would appear to be against the interests of the customers. We show, however, that side payments help the port authority to overcome the problems of market power, benefiting both the port authority and the customers. Further, these contracting outcomes are socially preferred to the unregulated outcome where port authorities and towage operators set prices and quality independently. This analysis sheds light and generally supports the Productivity Commission's recommendations.