AUCTIONS WITH AND WITHOUT THE RIGHT OF FIRST REFUSAL AND NATIONAL PARK SERVICE CONCESSION CONTRACTS

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1 AUCTIONS WITH AND WITHOUT THE RIGHT OF FIRST REFUSAL AND NATIONAL PARK SERVICE CONCESSION CONTRACTS HAYLEY H. CHOUINARD The National Park Service has struggled to improve the quality of service provided by concessioners for decades. To address these concerns, the Park Service eliminated the right of first refusal from the largest revenue-generating concession contract auctions beginning in 000. This article provides models of concession contract auctions with and without the right of first refusal. The optimal bidding strategies and expected level of service are found. The results confirm the auction without the right of first refusal leads to bids that include a higher level of service. Key words: auction, concession, National Park Service, right of first refusal. Soggy hamburgers, dirty bathrooms, cold showers, and poor postcard selection have been only a few of the complaints raised against National Park concessioners. Visitors have voiced such annoyance with poor concession service for decades. The Park Service recently changed the method to award the largest revenue-generating concession contracts in hopes of increasing the level of service. This work compares two auctions used to allocate concession rights to determine which leads to contracts with higher service included. Since its creation in 1916, the National Park Service has been attempting to balance its dual objectives of promoting the use and conserving the sites under its charge. Currently, the Park Service administrates over 83 million acres of land. These lands comprise 379 sites in 49 states (none in Delaware), the District of Columbia, and many U.S. territories (National Park Service 1999). In 000, the number of recreational visitors totaled more than 85 million (National Park Service 001). To meet the needs of visitors at many diverse sites, over 630 monopoly concessioners provide food, lodging, shopping, transportation, and other services. This is big business. These concessioners grossed over $765 million in revenues in 1998 (General Accounting Office 000). Hayley H. Chouinard is an assistant professor in the School of Economic Sciences, Washington State University. The author wishes to acknowledge helpful comments from Peter Berck, Michael Katz, Jeffrey LaFrance, Jeffrey Perloff, Michael Ward, and two anonymous reviewers. Any remaining errors are the author s. In efforts to protect the natural sites, the number of concessioners has been limited inside National Park boundaries since the mid 190s. In hopes of obtaining the efficiency described by Demsetz from franchise bidding, the Park Service implemented auctions for monopoly concession contracts. Due to the political influence of powerful concessioners in 1965, the contracts all included the right of first refusal. This right gives incumbent concessioners the option to match the best bid by a potential entrant in subsequent auctions. The right of first refusal exists in many different types of contracts. Undeveloped land, residential property, and commercial property contracts all may include the right of first refusal to provide current tenants the option to purchase the property. Securities sales by owners often allow other owners the right of first refusal in order to control ownership. Employment contracts, especially those of athletes and entertainers may empower the current employer with the right of first refusal as encouragement to support those unproven talents early in their careers. Various types of investment settings provide investors the right of first refusal on the developed innovation as an incentive to invest in research (Walker). Some question the gains from including the right of first refusal in many contracts. Government officials blame the right of first refusal for insulating incumbent park concessioners and providing incentives for them to provide poor service. The General Accounting Office (GAO) prepared several documents espousing Amer. J. Agr. Econ. 87(4) (November 005): Copyright 005 American Agricultural Economics Association

2 Chouinard National Park Concession Auctions 1083 the low-quality service by many concessioners, and directly attributes this to the inclusion of the right of first refusal in the concession contracts (General Accounting Office 1976, 1995, 1996, 000). The GAO suggests that the right of first refusal limits the number of bidders and results in non-competitive bids that promise fewer and lower quality services. The empirical study by Reece suggests that bidding for offshore oil tracts does not result in a competitive outcome, due to the small number of participants. Many critics of the concession auctions also claim that the right of first refusal limits competition in the bidding process, which generates noncompetitive results. They propose the elimination of the right of first refusal in hopes of driving the bids to more competitive levels. Beginning in May 000, the National Park Service concession contracts for the concessions grossing revenue of $500,000 or more annually, not including guides or outfitters, no longer include the right of first refusal. In an attempt to return to its mission of promoting use of the parks, the Park Service hopes these new contracts will lead to more competition for the concession contracts, better service, and more visitors (National Park Service 000). Instead of committing resources to monitoring and enforcing the provisions of current contracts, the Park Service is relying on a change in the concession right allocation mechanism to improve service. Two characteristics of the Park Service in part explain this action. First, the Park Service has not been satisfied with the level of service described in the bid proposals. The Park Service is seeking more serviceoriented concession contracts. Second, budget problems have limited the concession division of the Park Service. Few resources currently exist to increase contract enforcement. Prior to the elimination of the right of first refusal for some concession contracts in 000, only seven out of approximately 1,900 bidding incumbent s have been replaced by entrant bidders (National Park Service 000). On January 30, 00 the National Park Service announced the loss of the general store concession contract in Yellowstone National Park held by Hamilton Stores Incorporated. Delaware North Parks Services, which runs concessions in Yosemite and several state parks, won the contract. According to Stark, Karen Wade, Director of the National Park Service Inter-mountain Region, claimed Delaware North was evaluated favorably due to its environmental, interpretive, resource management, and education programs. Wade stated, The choice was made to provide the highest quality of visitor services to Yellowstone while ensuring protection of the park resources. Hamilton Stores had operated in Yellowstone for 87 years. This marks the first loss by an incumbent concessioner under the new auction rules, and the expected provision of service appears to have played a significant role. This article is the first to model the National Park Service concession contract auctions with and without the right of first refusal. Others have begun to consider the theory of the right of first refusal. Walker examines the legal aspects of the right of first refusal. He provides an excellent discussion of the purpose and uses of the right, including insuring against bargaining breakdown and inhibiting exit from a market, but also warns of the potential to limit competitive bidding. In the first economic analysis, Kahan models the value of the right of first refusal in negotiations. He logically presents that the value of the right will depend on the relative valuations of the goods. This work will also show the importance of different valuations on the effects of the right of first refusal. Kahan does not consider the right of first refusal in an auction context. Additional theory and an experimental examination of the right of first refusal is presented in Grosskopf and Roth. They conclude that the specific characteristics of the right can work to advantage or disadvantage the right holder. The specific right examined here will only serve to benefit the right holder. Finally, Bikhchandani, Lippman, and Ryan discuss the impacts of the right of first refusal on the seller and potential buyers. They rigorously model the right in a second price auction, and conclude that the right is inefficient (the bidder with the highest value does not necessarily win), and the seller will forego surplus. Using techniques similar to Bikhchandani, Lippman, and Ryan, first price auctions with and without the right of first refusal are modeled here to analyze the effects on the contracted level of service from each auction the Park Service currently administers. In order to determine the impacts of including the right of first refusal in concession contracts, incumbent and entrant bidders are assigned. These auctions and optimal bids are compared to determine the effects on the seller of the right of first refusal. This provides insight into how these auctions elicit service contracts from concessioners, and will aid in determining if removing the right of first refusal increases

3 1084 November 005 Amer. J. Agr. Econ. the contracted level of concession service. The assumptions maintained for the auctions are given in the next section. The third section contains a model of an auction with the right of first refusal. An auction model without the right of first refusal appears in the fourth section. A comparison of the auction results is discussed in the final section. Assumptions The bids represent the amount of service provided to the seller. In actuality, the concession contract bids comprised an enumeration of the service to be provided and a franchise fee to be paid to the Park Service. A minimum acceptable franchise fee is published by the Park Service. A large preponderance of bidders use this fee amount when submitting bids. The franchise fee is held constant across bidders, which implies that a higher bid represents more stated service in the bid proposal. A minimum bid level is announced prior to the auction, and no bid below the predetermined lower limit, b l, will be accepted. The Park Service sets these lower limits for the bids. Although this provides another instrument for the Park Service to increase the contracted level of service, the Park Service has not made use of it. The lowest acceptable bids has not been adjusted for several years. The Park Service prefers bidders to decide the services to be offered, and then evaluate the bids upon submission (Pearson). Two risk-neutral bidders may submit bids in the auctions. One bidder is randomly selected to serve as the incumbent and the other acts as the entrant. This models a concession contract already in existence, not a new contract where both bidders would be entrants. This is done as new concession opportunities are rare. Allowing only two bidders highlights the differences between the incumbent and an entrant. In previous renewal auctions, very few potential entrants have submitted bids. Prior to the removal of the right of first refusal, no more than four entrants have submitted bids for a renewal contract (Pearson). As a private value auction, the value of the right will vary with the characteristics of the bidder. These characteristics are only known to the bidder. An entrant may operate with lower costs than the incumbent, as may be the case with the 00 winner of the general store concession in Yellowstone. This bidder operates concessions in other parks, and may experience economies of scale that lower this bidder s costs below those of the incumbent concessioner. All else equal, this entrant would have a higher value than the incumbent. The costs of submitting a bid, although substantial, are considered sunk and not included in the analysis. The fixed costs including the payment of possessory interest to the incumbent by a winning entrant are also not part of the bid. These costs may determine whether a bid is submitted, but will not affect the level of the bid. Only variable costs affect the value of the concession right. In the Park Service auctions, a winning entrant must pay the incumbent all possessory interest for capital owned by the incumbent. The Park Service will provide an estimate of the value, but the entrant and incumbent must agree on terms. Here, it is assumed that this occurs as a simple transfer and has no effect on the bidding behavior. According to Stark, the negotiations for transfer of possessory interest in the general stores in Yellowstone did not begin until after the entrant bidder was awarded the contract in 00. An Auction with the Right of First Refusal The seller puts the right to operate as a monopoly for one period up for bid. This is a two-stage auction. The entrant bids in the first stage. After the incumbent learns the entrant s bid, the incumbent submits a bid in the second stage. The incumbent wins the auction if the incumbent s bid is at least some arbitrary small amount,, more than the entrant s bid. Otherwise, the entrant wins, given that both bids are greater than or equal to b l.ifnobid greater than b l is submitted, the seller will operate the monopoly. A winning bidder transfers its bid amount to the seller, and operates the monopoly. The incumbent and the entrant have private valuations, v I and v E, respectively. Each believes the other s valuation is uniformly distributed on [0,1]. The fact that each knows the other s distribution of value is common knowledge. Each bidder s value depend on the bidder s characteristics. These characteristics are not known to the other bidder. In the first stage, the entrant will maximize the expected value of winning the contract when selecting a bid. Using backward induction, the entrant will consider what the incumbent will do in the second stage. The entrant knows that if his bid is not greater than the incumbent s value, the incumbent will always

4 Chouinard National Park Concession Auctions 1085 win the auction as the incumbent may exercise the right of first refusal. Thus, the probability the entrant wins the contract is the probability the entrant s bid is greater than the incumbent s value. If the entrant s bid is less than the incumbent s value, the incumbent will match the entrant s bid and the entrant will lose the contract. Therefore, the expected value is the entrant s value of the monopoly right less the bid, multiplied by the probability that the entrant wins the contract. The entrant s maximization problem is (1) max b E [v E b E ]Pr(b E >v I ). To solve for the entrant s optimal bid, the probability the entrant wins must be considered further. The entrant knows the incumbent s value is distributed uniformly. Therefore, the entrant s probability of winning is b E. The entrant s objective function can be simplified to () (3) max b E [v E b E ]b E. The associated first-order condition equals v E b E = 0. Solving for the optimal bid yields b E = v E. This will be the entrant s bid as long as this is greater than the lower bound. Otherwise, the entrant will bid the lower bound if it results in a positive expected value. The entrant s complete optimal bidding strategy is represented in the following array (4) v E if b l v E b E = b l if v E b l v E 0 otherwise. In the second stage, the incumbent will maximize the expected value of winning the contract. The incumbent knows the entrant s bid prior to submitting a bid. If the entrant bids an amount less than the incumbent s value, the incumbent will match the entrant s bid plus.if the entrant bids an amount larger than the incumbent s value, the incumbent will not match. If the entrant does not bid, the incumbent will bid the lower limit. The incumbent s complete strategy is b E + if b l b E <v I (5) b I = b l if b E = 0 and b l <v I 0 otherwise. The entrant and the incumbent maximize their payoffs while considering the action of the other. These bids exist as a Bayesian Nash equilibrium for the auction. Both the entrant and the incumbent optimally respond to the strategies of the other when determining their own bidding strategies. An Auction without the Right of First Refusal The assumptions applied to the auction without the right of first refusal are identical to the previous auction with the exception that the bidders simultaneously submit bids. In the first-price, private value auction model, as described by Milgrom and Weber, Milgrom (1985, 1987, 1989), McAfee and McMillan, and Wolfstetter, the optimal bidding strategy is [(N 1)/N] v, where v is the bidder s valuation of the goods drawn from a unitary uniform probability distribution function, and N is the number of bidders. This bidding strategy represents a tradeoff for the bidders between the probability of obtaining the object, and enjoying economic rent from purchasing the object for less than the winning bidder s value. The lower bid level will influence the unconstrained private value solution. The complete optimal bidding strategy for both the incumbent and the entrant equals (6) v i if b l v i b i = b l if v i < b l v i 0 otherwise. The incumbent and the entrant are symmetric so the Nash equilibrium bidding strategies are also symmetric. The entrant s bid here is equivalent to the entrant s bid in the first-price auction with the right of first refusal described earlier. This result is a bit surprising, in that the entrant does not bid differently when faced with an incumbent with the right of first refusal. However, the entrant still trades off the probability of winning with the value of winning the right. Comparison of the Auctions The expected value of the auction to the seller is a function of the bid strategies. The bids represent the amount of service to be provided by the bidder. By examining the seller s expected value, a comparison of the service level offered under each auction can be made.

5 1086 November 005 Amer. J. Agr. Econ. The expected seller value for the auction with the right of first refusal can be written as (7) E[value] {{ } ( = Pr b l v ) E ( )} +{b l }Pr b l v E Pr(b E >v I ) +{{b E + }Pr(b l b E <v I ) +{b l }Pr(v E < b l <v I )}Pr(b E <v I ). If the entrant submits a positive bid, the expected value to the seller is approximately equal to the entrant s bid. The expected seller value for the auction without the right of first refusal equals (8) E[value] {{ } ( = Pr b l v ) E ( +{b l }Pr b l v E {{ } ( vi + Pr b l v ) I +{b l }Pr ( vi b l v I )} Pr(v E >v I ) )} Pr(v E <v I ). This expected value to the seller is equal to the sum of the entrant s and incumbent s bid in expectation. The entrant s bid will be the same under either auction. Therefore, the expected value to the seller is larger under the auction without the right of first refusal by the amount the incumbent bids over the entrant in expectation. 1 Furthermore, the auction with the right of first refusal is not Pareto Optimal. If the incumbent has a value greater than half the entrant s value, but less than the entrant s value, the 1 This will not hold if the lower limit is larger than the entrant s or incumbent s value. If the lower limit is greater than both values, no positive bid will occur in either auction. If the lower limit is larger than only the entrant s value, the incumbent will bid the lower limit in the auction with the right of first refusal, and will bid the larger of the lower limit or half its value in the auction without the right of first refusal. Thus, the value to the seller in the auction without the right of first refusal will be at least as large as in the auction with the right. If the lower limit is larger than only the incumbent s value, the entrant will bid the same amount under either auction, and the seller s value will be the same. incumbent will win the contract with a value less than the entrant s. The auction without the right of first refusal is Pareto Optimal. The bids are symmetric and increasing. The bidder with the highest value will win the auction. The expected value to the seller without the right of first refusal will always be greater than or equal to the seller s expected value with the right of first refusal. Therefore, eliminating the right of first refusal will always result in equal or higher contracted concession services. Removing the right of first refusal from the concession contracts will most likely meet the Park Service s objective of increasing the contracted level of service by concessioners. References [Received XXX????; accepted XXX????.] Bikhchandani, S., S. Lippman, and R. Ryan. On the Right of First Refusal. UCLA Anderson School of Management Working Paper, 00. Demsetz, H. Why Regulate Utilities? Journal of Law and Economics 11(1968): General Accounting Office. Concession Operation in the National Parks Improvements Needed in Administration. Technical Report RED (1976).. Federal Lands: Concession Reform is Needed. Technical Report T-RCED/GGD-96-3(1996).. Federal Lands: Views on Reform of Recreation Concessioners. Technical Report T- RCED-95-50(1995).. Park Service: Need to Address Management Problems that Plague the Concessions Programs. Technical Report RCED-00-70(000). Grosskopf, B., and A. Roth. If You Were Offered the Right of First Refusal, Should You Accept? Harvard Business School Working Paper, 003. Kahan, M. An Economic Analysis of Rights of First Refusal. New York University Center for Law and Business Working Paper CLB , McAfee, P., and J. McMillan. Auctions and Bidding. Journal of Economic Literature 5(1987): Milgrom, P.R. Auction Theory. Advances in Economic Theory. Econometric Society Monographs (1987):1 3.. Auctions and Bidding: A Primer. Journal of Economic Perspectives 3(1989):3. Q1

6 Chouinard National Park Concession Auctions Social Goals and Social Organization: Essays in Memory of Elisha Pazner. Cambridge: Cambridge University Press, Milgrom, P.R., and R.J. Weber. A Theory of Auctions and Competitive Bidding. Econometrica 50(198): National Park Service. Concession Reform. Available at: aff/issues/ concess.html (000).. Listing of Acreage by Park. Available at: acreagebypark99cy.htm (1999).. National Park System Visitation Report. Available at: npstats/systemrpt.cfm (001). Pearson, J., Senior Accountant, National Park Service Concession Program Division (Personal correspondence). Reece, D.K. Competitive Bidding for Offshore Petroleum Leases. Bell Journal of Economics 9(1978): Stark, M. Yellowstone Stores to Keep Familiar Faces. Billings Gazette February 1, 00. Walker, D.I. Rethinking Rights of First Refusal. Stanford Journal of Law, Business and Finance (1999):1 58. Q Wolfstetter, E. Auctions: An Introduction. Journal of Economic Surveys 10(1996):

7 Queries Q1 PE: Please provide article history. Q Author: Please provide volume number for reference Walker (1999).