FOREWORD
Privatisation, the transferring of property rights (generally in major utilities) from government to private hands, is now being recognised by governments across the political spectrum in many parts of the world as a practical way of reducing waste, inefficiency and economic loss to the community.
Despite growing concern about the need for Australia to improve its economic performance, there are ominous signs that it is being left behind in a fast-changing world. After its long history of good fortune, ossified attitudes and structures of privilege are not dislodged easily.
Those with a vested interest in opposing privatisation -- career and status-conscious administrators, feather-bedded employees, suppliers and users of subsidised services and other special client groups and beneficiaries -- remain major obstacles to reform, even as Australia's long-term economic malaise continues to deepen and it becomes increasingly plain that changes must be made. We have the odd spectacle today of government monopolies spending large budgets on television advertising to defend their performances, and by implication their privileged, protected positions.
It is tempting for politicians to protect obvious advantages for a few voters even if it means greater but diffuse and less obvious economic harm for many.
The community at large which stands to gain from privatisation is not, election results indicate, opposed to it at the polling booth, but more than vague or glib political rhetoric is still needed to establish its credentials. It must be seen as being immediately realistic, workable and effective.
In this study Richard Wood goes beyond rhetoric to examine the effects of privatisation with detail and economic rigour. He examines the performance of some major public utilities and the unacknowledged motives that may be behind some of their policies. His conclusions are realistic rather than Utopian, and the lessons he draws make important reading for those with an interest in political and economic decision-making, and in the future of Australia's economy.
Hal Colebatch
INTRODUCTION
Examining the output, employment, prices and wages policies of publicly-owned utility industries (such as those which supply electricity, telecommunications, postal services, natural gas, rail transport, and so on) provides insights into both possible gains from privatising government-owned enterprises, and some trade-offs involved in choosing different methods of doing so.
In this paper, we first review some of the evidence on the operation and management of public utilities with particular emphasis on electricity supply and telecommunications. We then argue that the common elements in the policies of various state-owned industries arise from the fact that they are organised along similar institutional lines.
In particular, we focus on the incentives inherent in organising production in government-owned monopolies. The incentives faced by management and employees in a government-owned monopoly are then contrasted with those in a privately-owned firm operating in a competitive market. Using these insights, we are able to elaborate on some potential gains from privatisation. The discussion also highlights some possible difficulties with privatisation, and demonstrates that the gain cannot be expected to be independent of the chosen method of privatisation.
Since we are interested in analysing the effects of institutional arrangements per se, we do not base our argument on assumptions of systematic differences in the attitudes, personalities or abilities of politicians, bureaucrats or private sector workers or managers. This is not to say that individuals don't matter. Neither is it suggested that there are no altruistic politicians, or dedicated bureaucrats. Rather, we argue that incentives point in other directions, and that not only does this explain much about the general features (1) of the behaviour of government monopolies and private firms, but suggests that the only reasonable approach to an evaluation of the consequences of different institutional arrangements is one which focuses on incentives.
PART 1
CASE STUDIES OF PUBLIC UTILITY OPERATIONS
This section summarises some important features of the operation of two publicly-owned utility industries in Australia. It is based on research done at the Centre of Policy Studies and shall be used in the next section as a bench-mark against which theories of the operation of publicly-owned utilities can be judged.
In a report prepared for the Victorian Government, (2) staff at the Centre of Policy Studies made a simplified model of the State Electricity Commission of Victoria grid to obtain an idea of the costs of supplying incremental or marginal units of electricity to customers in Victoria in different "representative locations" and different "representative periods" of the year (See figure 1).
Figure 1: The concept of marginal cost
It is important for consumers to know these costs if resources are to be used to our greatest benefit. If consumers underestimate the cost of obtaining access to electricity they will tend to overuse it. Conversely, if prices exceed marginal costs, consumers could use more electricity at a cost to the community which falls short of the benefit to consumers.
An important issue to consider in the context of providing goods like electricity and telephone service is that many of the facilities are jointly provided for more than one consumer. For example, consumers wishing to use the telephone or electricity transmission system at one time of the day can use the same facilities provided to consumers at another time. Also, a major transmission link operating with excess capacity will simultaneously serve a group of consumers.
Given that it is costly to expand capacity, it would not be efficient to ensure congestion never occurs, or, in other words, to ensure that the marginal benefit of access capacity was always and everywhere zero and thus below its marginal cost. To ensure efficient use of community resources, it is important that prices charged at times or in locations where current facilities are congested reflect the marginal costs of expanding capacity or excluding other consumers from using the facility.
On the other hand, at "off-peak" times or locations, efficient prices will be lower since capacity is then essentially a "free good" (it has to be more than required by off-peak consumers in order to satisfy peak demand -- see figure 2).
Figure 2: Peak and off-peak marginal costs with discrete sized units
Further, marginal operating costs are likely to be higher in peak periods when gas turbines, oil-fired plants, or older, less efficient, plants are used to produce electricity.
While the Centre of Policy Studies model produced approximate estimates of the marginal costs of electricity supply in Victoria, it showed divergences between SECV tariffs and marginal costs and some important determinants of SECV costs.
The most important observation is that marginal costs of electricity generation and high voltage transmission vary by location and time much more than do tariffs. Further, while low voltage distribution, metering and billing costs vary by customer classification, the variation could not be large enough to account for the differences in tariffs by customer category: tariffs do not appear to be closely related to marginal costs.
While it might be possible for consumers to be categorised and charged different prices so that the average revenue raised from a given category of customers approximated the average costs of supplying that category, the actual tariffs charged by the SECV are not closely related to such categorised average costs. For example, the cost of electricity used for industrial, commercial and general lighting is much higher than marginal costs at any time. Even if tariffs were related to average costs, so that, for example, consumers in a particular group who made heavy demands on the system when it is operating at peak capacity were charged a higher average price, the prices would still be inappropriate. Total demand may be constrained in periods when costs are greatest, but no individual consumer would have an incentive to shift his demand through time.
Similarly, many tariffs charged by the SECV (and other Australian electricity supply authorities) are "block-declining". The larger the quantity of electricity purchased, the lower is the price charged for an additional unit.
One might be able to justify block-declining tariffs, and higher prices for customers with few alternatives to electricity as an energy source (and thus a lower sensitivity or elasticity of demand to price increases), as a relatively efficient means for raising revenue to cover losses in an industry with large economies of scale. In such an industry, marginal costs will be below average costs so that efficient pricing (prices equal to marginal costs) would not raise sufficient revenue to cover total costs (average cost times output -- See figure 3).
Figure 3: Costs under economies of scale
Costs can be covered with least sacrifice of efficiency by charging highest prices to consumers who are least sensitive, thereby reducing demand below the efficient level by the smallest amount (See figure 4).
Figure 4: Prices under economies of scale
However, we believe this is not the explanation of SECV tariffs. Firstly, the tariff structure is too different from the pattern of marginal cost variation over time, and the differences between prices and marginal costs are too great, for the tariffs to represent an efficiency-maximising deviation from marginal cost pricing. Secondly, our experiments with the model of the SECV grid suggested that the system was being operated in a region of decreasing returns to scale. As one would expect, there is little evidence of economies of scale (in the relevant operating range) in the generation of electricity. On the other hand, there are likely to be economies of scale in the distribution network. Overall, it seemed to us that marginal cost pricing, given the current pattern and level of demand, could very well raise sufficient revenue to cover costs. However, this assessment is qualified by the fact that the pattern of demand, and hence marginal and total costs, would be altered by the introduction of marginal cost pricing.
We argue further that block-declining tariffs actually used not only do not represent an efficiency-maximising attempt to cover total cost, but in fact lead to efficiency losses compared to marginal cost pricing. The theoretically ideal block-declining tariffs would have all consumers paying the same price for the last unit of electricity consumed. In fact, different consumers are charged a different price for the same product supplied at the same cost. For example, the average commercial customer of the SECV, purchasing electricity for uses other than lighting, would not consume beyond the second step of his block-declining tariff, whose price is more than double the price paid by other consumers. By charging different prices for the same product, the tariff produces inefficiencies since electricity is not consumed where its marginal benefits are greatest, or conserved where the benefit falls short of the cost.
Figure 5: Price discrimination to raise total demand
While it appears that high tariffs for customers with a low elasticity of demand have little to do with efficiency, it is probably not coincidental that they are a good means of raising revenue to subsidise consumers whose demand is more sensitive to price, so expanding overall demand for electricity. Similarly, while the SECV offers some very limited off-peak tariffs for some commercial and industrial customers, these appear to be designed to "fill in the valleys" in the weekly and daily patterns of demand more than to "lop off the peaks". In short, the deviation from marginal cost pricing represented in the current tariffs serves to increase the demand for capacity in the system.
The subsidy to rural customers of the SECV embodied in the current tariffs might be thought more directly the result of political influence on SECV policy. While the political influence of rural consumers is probably relevant, as we shall see, such a tariff differential may also operate to increase the geographical extent of the distribution of large quantities of electricity. Hence, it may not be inimical to the interests of SECV bureaucrats and engineers. Furthermore, maintenance of cross-subsidies to rural customers gives politicians a good reason for supporting the state-wide monopoly of the SECV and, for this reason alone, would be an attractive strategic policy for SECV bureaucrats.
Other features of SECV operations as well as pricing policy are of interest. For example, why does the SECV not offer more specialised contracts allowing for interruptibility or the repurchase of excess privately-generated power at its marginal value to the system? Such contracts would facilitate better management; their under-utilisation suggests economising on system capacity is not important to the management. The use of brown-outs or black-outs instead of interruptible supply contracts appears to raise the (political as well as economic) cost of shortages of capacity, leading to a greater demand for reserve capacity than would otherwise be the case.
Some commentators on the SECV (and other public electricity supply authorities in Australia) claim there is extreme over-manning in both the construction and operation of power stations compared with foreign and privately-owned Australian plants using a similar technology. The Australian public utilities also appear to have less incentive to reduce construction costs than do private firms undertaking comparable projects. Maintenance of SECV power stations appears to be worse than maintenance of the privately-owned station at Anglesea. Finally, the workforces in public electricity authorities appear to be organised into strong and militant trade unions which have often met little resistance from their government employer to their demands.
If we examine the pricing and production decisions of Telecom Australia, (3) we can see similarities to the policies of the SECV discussed above. First, the tariffs do not appear to be closely related to marginal costs. While there is some variation in trunk charges (4) by time, this would not match the variation in marginal costs. (5) As with the SECV this would tend to raise the demand for system capacity. An offsetting factor in the case of Telecom is that the revenue raised from trunk calls as a whole appears to exceed the costs of providing the service. While some of this may come from off-peak trunk charges being considerably in excess of off-peak trunk costs, it is also possible that peak trunk charges could exceed costs. The complicating factor is that peak trunk calls are likely to be made principally by businesses and hence the elasticity of demand may be much lower for this group of customers. The twin aims of subsidising the demand for capacity and raising most revenue from customers with the lowest elasticity of demand would in this instance come into conflict.
On the other hand, there is no doubt that rural connections to the network are subsidised. As in the case of the electricity industry, we shall argue that this cross-subsidy no doubt owes much to political influence. Nevertheless, Telecom management and employees probably are not opposed to its tendency to expand the geographical extent (and possibly labour intensity) of Telecom's operations.
Another similarity between Telecom and the SECV is the use of non-price as opposed to price rationing. In the SECV, non-price rationing takes the form of increased black-outs and brown-outs, a less stable supply and less prompt service in rural areas; and the lack of flexible contracts (with interruptibility or buy-back provisions for example). In Telecom, we find variations in the quality of service and speed with which maintenance is performed, as well as queues for connections.
An interesting difference between Telecom and the State electricity authorities is that competition with Telecom is explicitly prohibited by legislation, whereas only in some states of Australia is it necessary to get the permission of the electricity authority before power can be privately generated. This differing legal situation may be related to differences in the economic structure of the two industries. In the electricity industry, only in the power distribution grid is there a reasonable presumption of large economies of scale (or natural monopoly).
However, with government ownership of the grid, private generation can be discouraged by paying a very low price for electricity supplied to the grid. In addition, the state electricity authorities are not called upon to pay income tax, are given preferred access to "dedicated" coal deposits, may borrow with government guarantees, and are generally able to use the state as an insurance agency if pricing and investment decisions should turn out to have been mistaken. (6)
In contrast to the electricity industry, it seems that trunk-line operations in telecommunications may exhibit approximately constant returns to scale. In telecommunications, natural monopoly elements in the industry are most likely to exist in the local networks, and government ownership does not suffice as a mechanism to squelch competition in the decreasing or constant returns to scale part of the business. Instead, competition has to be explicitly excluded by statute.
PART 2
A MODEL OF PUBLIC UTILITY OPERATION (7)
In this section we discuss a simple model (8) of public utility operation and show how it can account for the regularities discussed in the previous section. The purpose of such a model is that we can use it to analyse the likely consequences of altering institutional arrangements. In fact, any assertion about the likely result of institutional changes must at least implicitly be based on some theory about the way different institutions alter incentives to produce different results.
Our starting-point is the assumption that decision-makers (both politicians and enterprise managers) are concerned about non-pecuniary benefits as well as monetary payments. A traditional assumption in economic models of bureaucracy is that bureaucrats want to maximise the output of the bureau. Others have suggested that engineers working in the bureau may desire to maximise the amount of engineering input into projects. More generally, we could think of managers as desiring some combination of inputs (which could correspond to output but may include plush offices, and fancy technology). However, managers will also have to contend with employees, who will have their own goals. Economists studying trade unions have suggested that a good characterisation of the aims of union leaders is that they attempt to maximise some combination of the wages paid to their members and the level of employment of their members. (As a special case, they may be interested in the total wage bill paid to their members). Depending on the relative bargaining strengths of the managers and workers, enterprise employees as a whole will be attempting to increase employment and wages with varying degrees of emphasis on each goal.
We would expect politicians to be concerned with the decisions of the utility and therefore to have an incentive to monitor it. However, it will not be in the private interests of politicians to ensure the enterprise operates efficiently. Each politician will be attempting to maximise the personal satisfaction and benefits from being an elected representative, but his actions will be constrained by the requirement that he gain enough votes to remain in office in the face of electoral competition from a representative of another party. (9)
While we might expect electoral competition would tend to result in policies favoured by a majority of voters, there are several complicating factors. Information is costly to obtain and disseminate, so that both government and opposition parties will always be uncertain of the effects of policies. As a result the status quo is automatically accorded an advantageous position. Also, voters will have an incentive to discover most about those policies most likely to affect them. It would not be very wise for a voter to attempt to determine the effect of policies which he expects, a priori, would have only indirect or minor relevance to him. Therefore policies which impose costs of minor relevance on a large number of voters, but bestow major benefits on a few, are likely to be successful.
Finally, in a majority-rule system, politicians, and thus their supporters, must compromise to form a winning coalition. Even if voters knew certain policies had small detrimental effects on them, they would agree to such policies if, in exchange, they could get others to support policies with large beneficial effects.
In short, a representative political system based on majority rule will result in government policies which favour a coalition of minorities at the expense of voters not in the coalition. A party could gain (and hold) office by proposing and implementing inefficient policies if the costs were dispersed across many voters and there are significant benefits to a politically influential group. We should also note that inefficient policies may be far more effective at disguising the transfer than more efficient alternatives, and so may actually achieve a greater redistribution for a given political cost.
When establishing a public enterprise, politicians will have an incentive simultaneously to establish some procedure for monitoring it (such as reports to Parliament or accounting practices) to ensure it behaves in accordance with the political goals of the government. Since private ownership of the net income of the enterprise is absent, profitability, or an adequate return on capital invested in the enterprise, will not be the most important goal. The implication is that the goals will be diverse and may change over time.
It will be much more costly to monitor the achievement of a diffuse and poorly defined set of goals than to check on profitability. Further, monitoring or accounting procedures effective for furthering one goal may not be effective for others. The most desirable level of investment in any one set of procedures will depend on the anticipated returns. Since the goals of the monitors of public enterprises can change from period to period, the optimal investment will be less than for a private firm with an unchanging goal. Finally, when the enterprise is being established, it may not be in the interests of the incumbent party to make it too easy to force the enterprise to behave in accordance with the governments' objectives. Supporters of the government may prefer to under-exploit their power to control the enterprise so that the opposition might also be less effective if it became the government. In short, the preferred degree of monitoring or control of public utilities by politicians may be quite small and aimed at more diffuse goals than profitability or an adequate return on the investment in the enterprise.
Given that the quality of service provided by the utility can be varied in many dimensions, politicians will find it very difficult to determine the level of service being provided to consumers. On the other hand, it will be much easier to determine the prices consumers are being charged. Parliament can also impose on the state enterprise the requirement that its total revenue equal total operating costs (or differ from them by some fixed tax payment to Treasury or subsidy from general revenue).
Based on these considerations, we could approximate the goals of management (10) of state enterprises as some trade-off between increased employment and higher wages. However, managerial discretion is limited by markets arid politically-imposed constraints. First, politicians could be reasonably assumed to be capable of forcing the utility to keep total costs equal to total revenues net of taxes. The taxes are payments to Treasury which could represent, for example, turnover taxes or "artificial" (typically artificially low compared with comparable private returns on capital) legislated rates of return on capital assets. Second, politicians are assumed capable of specifying prices for different consumer groups. In effect, the costs to politicians of monitoring prices are assumed to be much lower than the costs of monitoring levels of service. By spending more on monitoring, the politicians are assumed to be able to force the utility to supply a level of service closer to the demand of customers at the politically-set prices. Managers will also be constrained by markets. Wages paid to employees must be at least as great as they could earn elsewhere, while output is limited by the amount demanded by consumers at the prices set by politicians. The conferring of monopoly status on the utility could be seen as an attempt to increase demand at each price.
In turn, (11) the politicians are assumed to set prices, a tax rate and a level of monitoring so as to maximise a "political support function" subject to the constraints that:
- employment, output and wages for a given setting of prices, tax rates and monitoring expenditure are chosen by the utility managers;
- wages do not fall below the competitive payments employees can receive in alternative employment;
- output does not exceed demand at the prices set by the politicians.
The "political support function" depends on the consumer surplus received by special interest groups, and the overall net contribution to general revenue after allowing for monitoring costs.
This set of assumption yields a model of the management and control of government-owned enterprises. While such a model is necessarily a rough generalisation, we can nevertheless show that it implies government enterprises would tend to behave in many of the ways we see them behaving. This in turn gives us confidence that the model can be used to investigate the likely consequences of organising production into public monopolies as opposed to private competitive firms.
One implication of the model is that output may equal that achieved under average cost pricing. But for a firm whose technology displays short-run decreasing returns, average cost pricing will lead to an over-expansion of output, which is consistent with our observations in the previous section. The over-expansion of output arises because the returns to capital are used to fund current operating expenses. Compare this with the situation of private firms. They have to compete for investment funds by offering a competitive return on capital. Equity and bond markets can be viewed as markets which trade rights to corporate profits. The prices of a firm's shares or bonds give an easily-observed measure of managerial performance.
In addition, individuals who can improve on managerial performance can buy a majority interest in the firm and gain financially from any improvements they make. Similarly, taxpayers might be thought of as the nominal owners of a government firm. However, rights to the return on capital in a publicly-owned firm cannot be traded. It is more costly to monitor managerial performance than for a private firm and there is less incentive to do so. The return instead tends to be dissipated on current expenditures with taxpayers called upon to finance investment.
The model is further able to demonstrate how output may deviate from the output achieved under average cost pricing depending on the influences of four factors. (12)
- The degree of political support enjoyed by different groups of consumers can influence the structure of prices, with favoured groups being charged a price below average cost and disfavoured groups taxed. When customers are a favoured (disfavoured) group the size of their subsidy (tax) will vary inversely with elasticity of demand, holding the effect of other influences constant.
- Non-price rationing may arise in response to differences in costs of monitoring prices and services. In particular, the utility may find it optimal to ration those consumers the politicians attempt to favour by lower prices. Non-price rationing may reduce output closer to the level which would be forthcoming under marginal cost pricing, but the non-price rationing may itself introduce inefficiencies as customers expend resources to move up queues, and services may be provided to those who value them less.
- To the extent that there are non-pecuniary benefits depending on something other than output, inputs will not be chosen to minimise costs. In this case, output will fall short of the output supplied by a cost-minimising firm pricing at average cost. However, the fact that output is not supplied at minimum cost will represent an inefficient use of resources. We should also note that the absence of an incentive to cost-minimise may lead to a de-emphasis of commercial skills in the internal incentive structure of the enterprise. On the other hand, any technical advance which enables a given output to be produced with fewer inputs will be of value to the managers, since then they can produce extra non-pecuniary benefits or make higher factor payments without altering output. This may explain the fact that many public utilities have internal management structures which reward technical but not commercial expertise.
- Finally, employees may be paid in excess of their competitive market wage, and this too will raise costs when compared with a cost-minimising firm which takes all factor prices as given.
Deviations between average cost pricing and actual tariffs were noted in our discussion of public utility policy in the previous section. These deviations can be related to each of the four factors just outlined. We observed that the relative prices charged to different customer groups were related to differing degrees of political support and differences in elasticities of demand. We noted that non-price rationing is often observed in publicly-owned utility industries. There is also some evidence that capital may be chosen in part to provide non-pecuniary benefits while employees are paid in excess of their competitive return. The apparently complex and inexplicable behaviour of publicly-owned utilities can in fact be explained as quite rational choices within the institutional framework.
The ability to use public utility prices to cross-subsidise favoured groups of consumers will give politicians an incentive to support the existence of a government monopoly, even though it is less efficient than delivering the same service using privately-owned competitive firms. Achieving the same cross-subsidy through explicit taxation may be less desirable for politicians. It is much easier for the taxed individuals to perceive the costs when taxes are explicit than when the taxes take the form of divergences between prices and marginal costs. Also, if competition with the public utility is allowed, the ability to charge some consumers in excess of marginal cost in order that other consumers may be subsidised is severely curtailed. The "taxed" consumers will instead purchase from private competitors leaving the public utility making operating losses on the services it provides to subsidised customers.
PART 3
THE PRIVATELY-OWNED FIRM
A series of recent papers, such as those by Jensen and Meckling [1976] and Fama and Jensen [1982], have examined the incentive structure of private firms. In owner-managed private firms, the owner-manager has an incentive to maximise the present value of his assets and generally reduce the cost of production. In large private firms, managers will normally be employed by the owners (share-holders) and this separation of ownership from management may reduce pressures on management to run the firm efficiently. So long as his individual share in profits remains small, any one owner will not have a great incentive to force managers to operate the firm efficiently.
However, competition between managers, and more particularly transferability of ownership, will limit the divergence between the aims of managers and share-holders. Furthermore, it will be in the private interests of those first establishing the enterprise to set up effective, low-cost mechanisms by which the share-holders can monitor the behaviour of managers. Only then will the value of shares in the enterprise be maximised.
It will also be in the private interests of subsequent share-holders to carry out the amount of monitoring implicit in the share's purchase price, for to do otherwise would result in a fall in the value of the shares.
If ownership becomes very diffuse and managerial efficiency declines, individuals (or other managers on behalf of individuals) will have an incentive to purchase a controlling interest in the firm, increase efficiency, and realise a capital gain in their shares.
In summary, transferable property rights will encourage the pursuit of profits and hence the search for ways of reducing production costs or producing more valued outputs. By contrast, we noted in the previous section that the absence of explicit claimants to the returns to capital in publicly-owned firms produces a bias in such firms towards an over-expansion of output and a general under-valuation of capital inputs.
PART 4
SOME LESSONS FOR PRIVATISATION
Having achieved some understanding of why publicly-owned firms behave the way they do, and compared their operation to privately-owned firms, we can outline some of the potential benefits and costs of privatisation. The monitoring of profit-maximisation tendencies of managers by share-holders is likely to produce more cost-effective production than the political monitoring discussed in the previous section.
However, privatisation alone is not sufficient to deliver the benefits of a market system. The other crucial ingredient is competition. While private ownership provides an incentive to maximise profit, and hence reduce cost, without competition the private firm will be able to charge a price in excess of its marginal cost. This, too, will result in an inefficient level of output. The cost to society of increasing output of the good in question would fall short of the benefits to consumers from doing so (See figure 6). While a publicly-owned monopoly will have a tendency to over-produce, a privately-owned one would have a tendency to under-produce.
Figure 6: Monopoly pricing and efficiency
Thus, many of the potential efficiency gains from privatisation may not be captured if the public firm is turned into a private monopoly. For many public utilities this might be thought to cause a serious difficulty. It is often argued that the technologies in these industries are such that even if a large number of competing firms start out in the industry there will be a tendency for just one of them to become dominant -- the industry is characterised as being a natural monopoly. The basic requirement for an industry to be a natural monopoly is that the average costs of producing output continually decline as more output is produced (See figure 2). In that case, the largest firm will always have the lowest cost and thus, it is argued, can undercut its competitors and drive them out of business. It is also argued that the economies of scale in setting up distribution networks turn many public utility industries into natural monopolies. However, while such economies of scale do appear to pertain to the establishment of an electricity distribution grid and a local telephone network, they do not apply to electricity generation or, particularly with recent technological innovations, the trunk telephone network. Thus, while the natural monopoly argument may provide a prima facie case for regulation of firms involved in providing local telephone networks and the electricity distribution grid, no such case is provided for regulation or public ownership of firms engaged in electricity generation or trunk telephone services.
In addition, the natural monopoly argument has itself come under increasing questioning in recent years.
Even if the largest firm has a cost advantage and drives its competition from the market, it may not then act as a monopolist. As soon as it attempts to charge prices in excess of its marginal costs it will provide an incentive for competition to enter the market and attempt to capture some of the monopoly profits. So long as the costs of entering and leaving the market are not too great such potential competition will limit the extent to which prices can exceed marginal costs. In short, the threat of competition might be nearly as effective in enforcing low prices as the presence of actual competitors.
Nevertheless, if maximum efficiency gains are to be obtained from privatisation, attention must be paid to the competitiveness of the resulting market structure in addition to the ownership of the firms.
The second lesson to be learned from the above analysis is that it will be virtually impossible to privatise most government enterprises without affecting adversely both the employees of the enterprise and some groups of consumers. The inefficiency of government ownership is associated both with the production of rents for employees and cross-subsidisation of some consumers by others. If we attempt to privatise while avoiding losses for these groups we will probably forego many, if not all, the efficiency gains. The efficiency gains from privatisation mainly take the form of a set of prices which more closely match marginal costs, a use of technology which minimises economic costs as opposed to employee welfare, and a level of output which more closely matches marginal costs with marginal benefits. One way of reducing costs for the affected parties is to phase the changes in gradually. However, this also delays the gains from the change, and may give opponents of the policy more time to prevent or obstruct its implementation.
The third lesson is that criticisms of privatisation on the grounds that only the profit-making parts of the business will be sold, leaving the taxpayers to fund the losses, largely miss the point. At the moment, taxpayers are called upon to fund investment in government-owned enterprises which earn less than the competitive return on invested capital. What should be a return to investing in the enterprise is instead dissipated in over-expansion, over-payment of employees, the use of inefficient technology or the subsidisation of some consumers.
In addition, the loss-making parts of the business are often cross-subsidised from other consumers. It is not as though privatisation introduces a new need for tax revenue -- if the cross-subsidised consumers continue to be subsidised, privatisation changes the form in which existing taxes are paid and who pays them. The advantage of privatisation, however, is that it reduces the cost inefficiencies which lead to a greater need for subsidisation in the current institutional framework.
The fourth lesson is that the way privatisation is carried out could make a difference to the efficiency gains. In particular, if shares in the new firm are widely distributed to consumers and former employees in an attempt to avoid disadvantaging them, the ownership in the new firm will be very diffuse. While it might become more concentrated over time, the Bell Group takeover bids for BHP in 1985 and 1986 illustrate that it can be difficult to discipline management in a widely-held firm. In consequence, the owners will place less pressure on management to maximise profits and hence reduce costs. In general, the government should choose a method of privatisation, and accountability of managers to share-holders, which maximises the sale value of the shares.
The final lesson from the above analysis is that the industries we choose to privatise should yield benefits concentrated on some influential groups in addition to the more diffuse efficiency gains. Since politicians appear to gain from government ownership it will be politically unpopular to privatise. How can the politicians gain even though the institution is less efficient? The basic reason appears to be that the costs are diffused over a large number of individuals (consumers and taxpayers) while the benefits of public ownership, while lower in aggregate amount, are concentrated on smaller groups (employees and favoured consumers) who are apparently more influential. Conversely, the benefits of privatisation will tend to be diffuse while the costs are concentrated. The most successful privatisations will therefore be those firms where government monopoly has begun to impose increasing costs on politically influential groups of consumers. For example, government monopolisation of Australian coastal shipping has gradually imposed greater costs on certain regions or industries (such as mineral processing). These groups might be expected to provide a political counter-balance to the employees who would be adversely affected by privatisation of the ANL coupled with an opening of Australian coastal trade to free entry. Similarly, those living in more distant parts of the continent might provide a powerful advocacy in favour of privatising TAA along with deregulating the domestic airline industry. As another example, the introduction of AUSSAT has provided an opportunity for AUSSAT and the trunk network of Telecom to be privatised, with the likelihood that a reasonably competitive long-distance telecommunications market could be produced, benefitting, in particular, users of such services for data transmission. In the case of the electricity industry, it would appear that considerable efficiency gains could be reaped by encouraging more private generation. This could be quickly done if co-generated power (that is electricity produced as a by-product from some other industrial process) were paid its marginal value to the system. Advances in electronic technology now make it more feasible to pay a time-varying price for privately-supplied power, while firms in a position to supply co-generated electricity might be expected to be strong advocates of a change in policy.
PART 5
CONCLUSION
We have argued that many of the peculiar features of utility operations result from the incentives inherent in government ownership of a legislated monopoly. These same incentives lead to the efficiency losses associated with government-owned firms. Privatisation of many government enterprises can lead to efficiency gains so long as care is taken to ensure the resultant market structure is competitive, that is, subject to freedom of entry and exit.
Privatisation is also likely to involve losses for those currently advantaged by government ownership. Attempts to reduce these losses by making the private ownership diffuse and expensive to trade will also reduce the pressure on management to behave efficiently. This, too, will be less of a problem if the markets are competitive. Other firms will then put some pressure on management to control costs even if shareholders have little incentive to do so.
Finally, we noted that privatisation is likely to be politically unpopular. We suggested that for this reason the best firms to privatise are those where some concentrated interests stand to gain from the increase in efficiency and/or removal of cross-subsidisation. In Australia, the most obvious candidates would appear to be the ANL and TAA. One might hope that those living in more distant parts of the continent would provide a political counterweight to the current beneficiaries of government ownership and regulation in the transport sector of the economy.
ENDNOTES
1. In contrast, some particular decisions of governmental (and private) bodies do appear to be explicable only if we also take account of some particular facts about the personalities or attitudes of important decision-makers. No model of private or public enterprise would be capable of ruling out magnificent, or disastrous, decisions in either enterprise due, say, to the presence of a brilliant, or hopeless, administrator. We cannot hope to explain all, but just theories which may illuminate the inherent features of the organisational form.
2. Centre of Policy Studies [19821, see also Hartley and Trengove [1984].
3. See Trengove [1982].
4. The costs of metering may exceed any benefits from peak-load pricing of local calls.
5. Under marginal cost pricing, demand would equal capacity in several periods so capacity costs would be spread over all these periods. Relative prices in the different periods would then be set to ration demand to the available capacity.
6. Recent changes of government policies, such as required rates of return on assets, valued at market prices, may have tipped the scales somewhat in the direction of private companies. Nevertheless, the price paid for private power has not been changed to reflect its marginal value to the system and many of the concessions to the state electricity authorities remain in place.
7. For further details of this model see Hartley and Trengove [1986].
8. The model can be complicated in various ways to increase the extent to which it accounts for the behaviour of public utilities -- see Hartley and Trengove [1985].
9. See for example Downs [1957], Breton [1974] or Mueller [1976] for similar models of the representative political system.
10. See Hartley and Trengove [1986].
11. Following Peltzman [1976]. See also Hillman [1982].
12. For further details see Hartley and Trengove [1986].
BIBLIOGRAPHY
Breton, A., The Economic Theory of Representative Government, Chicago, Aldine, 1974.
Centre of Policy Studies, Monash University, Energy Pricing Issues in Victoria, A report prepared for the Long Range Policy Planning Committee of the Victorian Government, Victorian Government Printing Service, January 1982.
Downs, A., An Economic Theory of Democracy, New York, Harper and Row, 1957.
Fama, E. and Jensen, M., Residual Claims and Investment Decisions in Organization, Mimeo, July 1982.
Hartley, P. and Porter, M.G., Pricing of Electricity and Questions of Ownership, paper prepared for the conference on the Economics of Electric Power Systems, AGSM, July 1983.
Hartley, P. and Trengove, C., "Who Benefits From Public Utilities?", forthcoming, in Economic Record, 1986.
Hartley, P. and Tengove, C., "The Marginal Costs of Electricity Supply in Victoria", Economic Record, December, 1984.
Hillman, L., "Declining Industries and Political Support: Protectionist Motives", American Economic Review, December 1982.
Jensen, M. and Meckling W., "Theory of the Firm: Management Behaviour, Agency Costs and Ownership Structure", Journal of Financial Economics, Vol. 3, 1976.
Mueller, D., "Survey on Public Choice", Journal of Economic Literature, Vol. 14, 1976.
Niskanen, W., Bureaucracy and Representative Government, Chicago, Aldine, 1975.
Peltzman, S., "Towards a More General Theory of Regulation", Journal of Law and Economics, August 1976.
Porter, M.G., (ed.), The Australian Monetary System in the 1970's, Monash University, 1978.
Swan, P., Pricing of Electricity to Alcoa at Portland, Victoria, Submission to Senate Standing Committee on National Resources, 1981.
Trengove, C.D., Telecommunications in Australia: Competition or Monopoly, Centre of Policy Studies Special Study No. 4, 1982.
No comments:
Post a Comment