Government has two roles when it comes to the design and operation of public service markets: it is both a player in the market and the regulator, with the responsibility for ensuring that the various participants play by the rules. There is potential for a conflict of interest between these two responsibilities, and if it is not recognised, government-as-customer may change the rules to the disadvantage of its suppliers, who will be unprotected by government-as-regulator.
There is an historical case study which demonstrates what can happen when these two roles are confused. Most public utilities - electricity, water and gas - and public transportation systems - heavy and light rail - were originally conceived and developed, financed, constructed and operated by private firms. For the most part, these were natural monopolies, so that franchises were let, and price and quality were regulated, by municipal authorities. There was a significant degree of lock-in under this model - municipal authorities and utility companies made irrevocable investments in these facilities, as did customers, and it was rarely feasible for other suppliers to duplicate them.
In time, for reasons of social policy and self-interest, local politicians began to behave opportunistically, suppressing prices 'in the public interest', and insisting that services be extended to remote corners of the municipality where the returns did not cover the investment. They exploited their powers as regulators to benefit themselves as the customers' agents, at the expense of providers who had made irrevocable investments.
Ultimately, this was commercially unsustainable, and there were two alternative models which resolved the impasse. The first was municipalisation - local authorities acquired the utilities and owned and operated them as public enterprises. Investors were often willing to sell their shares because it enabled them to recoup at least some of their investment.
The other stable solution lay in the take-over of the regulatory and price-setting functions by national or provincial governments. By removing price regulation out of the hands of the consumers' agents (municipal politicians), private utilities and their investors were reassured that long-term considerations such as return on investment would be taken into account.37
Contracts under the Private Finance Initiative (PFI) bear some similarities to utility franchises, particularly because of the sunk costs associated with infrastructure investments. But in some circumstances, private providers of public services may also find themselves locked into a market with high exit costs. Under these conditions, they will have few options, in the short-term at least, if the customer abuses its monopsony power and interprets the rules to its own advantage. Over the medium- to long-term, this will destroy trust in the integrity of the system and result in companies withdrawing from (or not entering) the market.