Proponents of privatization argue that transferring public enterprises to the private sector will expose these enterprises to the discipline of the market, and thereby lead them to increase efficiency.
Privatization and Efficiency
How can privatization be expected to make public enterprises more efficient? To answer this question, we need to distinguish between public enterprises that are already subject to national or international competition and those in a monopolistic position, by which is meant either total monopoly power or near-complete insulation from the pressure of competition.
In the first case, the forces of competition should provide the incentive for enterprises to seek out opportunities to increase both productive and allocative efficiency. In general, there are no strong grounds for public ownership of such enterprises, and sale to the private sector should be both straightforward and uncontroversial. Of course, some enterprises will have survived competition only with budgetary support. There may be compelling reasons why this support should continue—where enterprises have social obligations or where they serve strategic interests, for example—but, otherwise, it seems appropriate that commercial considerations should determine the viability of such enterprises.
Clearly much of the privatization that has occurred, both in industrial and developing countries, falls into this first category. It will have led, or is likely to lead, to some gains in efficiency, but the aggregate impact of such privatization is necessarily small, given previous exposure to competition under public ownership, and the fact that, in general, competitive firms account for only a small share of the public enterprise sector. The greatest benefits resulting from the privatization of such enterprises probably derive from the initial momentum given to a privatization strategy and the release of human resources which can be directed toward supervising the remaining public enterprises. However, large efficiency gains can be expected to come only from the privatization of public monopolies, and in particular large monopolies. To the extent that privatized enterprises are able to retain most of their monopoly power—either because statutory protection continues or because their cost structure implies that they are natural monopolies—the scope for improvements in efficiency relates primarily to what can be done to enhance productive efficiency. There is no reason to believe that the product mix produced by a private monopoly is valued more highly by consumers than that produced by a public monopoly, in which case no improvement in allocative efficiency is likely to emerge from privatization.
When a public monopoly is transferred to the private sector, the privatized monopoly will typically have to accept regulatory surveillance. In the United Kingdom, the privatization of British Telecom was accompanied by the creation of a regulatory agency, OFTEL (Office of Telecommunications), in recognition of the monopoly position to be retained by British Telecom. The recent sale of British Gas has seen the creation of a similar agency, OFGAS (Office of Gas Supply). The privatization of major monopolies should therefore be seen as involving a change in the nature of regulation (Rees (1986)).
A number of different arguments suggest that the replacement of a public monopoly by a regulated private monopoly will increase productive efficiency. Of these, three—the impact of reduced political interference, a change in property rights, and more effective financial management—should be emphasized.
Reduced Political Interference
If public enterprise managers cannot make decisions independently of the need to meet the demands of political expediency, privatization should improve the quality of managerial decision making. The record of political interference in the operation of public enterprises is bad, and the fact that governments in many cases retain a controlling interest in privatized enterprises implies that considerable scope for political interference will remain, even after privatization. However, in attempting to exercise this power, politicians are likely to face two constraints.
The first constraint is the regulatory framework, which is concerned not only with policing anticompetitive practices, but also with eradicating other sources of economic inefficiency, including attempts by politicians to affect economic decisions. To be effective, the regulatory agency should be invested with sufficient autonomy to limit the possibility of it being captured by particular interest groups. The second constraint is the existence of private shareholders, who can monitor the conduct and performance of the enterprise. While, in effect, every taxpayer/voter is currently a shareholder in the public enterprise sector, an explicit shareholding may induce those voters who hold shares to take a greater interest in the performance of public enterprises; politicians may therefore be required to act more responsibly as a result of privatization. Of course, if ownership is widespread this may not be an effective constraint. There might be better control if the majority of shares were in the hands of major financial institutions, which of necessity must monitor their investments very closely, indeed, this is one reason individuals prefer to hold shares in financial institutions rather than in specific companies. The resulting concentration of share ownership, however, is inconsistent with the object of achieving broad-based share ownership.
Changing Property Rights
It has been suggested that a change in ownership will affect the structure of property rights and thereby overcome existing bureaucratic failures. Shareholders will be aware of the possibility of takeover, and will set up incentive systems—featuring bonus payments or profit sharing, for example—that put pressure on managers to be more efficient. While shareholders may be better informed and more demanding principals than government because they share more directly the benefits and costs of the way a firm is managed, if the structure of operational control is largely unaffected by a change in ownership, there may remain a problem of asymmetric information. Thus, property rights theory suggests that managers of private monopolies are also able to take out part of the benefit a monopoly confers in the form of a quiet life. In addition, because private managers typically have greater discretionary power than public managers, they can, according to the theory, take advantage of the opportunity this presents to pursue goals that promote their own position and reputation, and so increase their personal rewards.
More Effective Financial Management
Upon privatization, an enterprise should relinquish access to direct financial support from the government. It will, therefore, be subject to the discipline imposed by the private capital market and the market for corporate control. The effectiveness of this financial constraint will depend upon the government’s resolve in resisting claims for direct support, or indirect support in the form of preferential treatment by the private capital market backed by an explicit or implicit government guarantee.
Although none of the above arguments unequivocally implies that privatization will significantly increase productive efficiency, some improvement is likely to result. While politicians may continue to interfere in privatized enterprises and while inefficient enterprises can satisfy their creditors and not be threatened by takeover, private monitoring of managers is probably more effective than public monitoring. Also, without the financial backing of government, the capital market will impose some pressure on enterprises to be efficient. Even so, substantial efficiency gains may well fail to be realized. Moreover, even if productive inefficiency is reduced considerably, allocative efficiency may be conceded in the process, and the actual gains in economic efficiency resulting from a change in ownership may prove relatively modest.13 The size of likely efficiency gains cannot, however, be determined a priori, nor is there sufficient quantitative information on which to base a judgment.
Privatization and Liberalization
While changes in ownership may be expected to produce some gains in productive efficiency, there is no reason to expect improvements in allocative efficiency. Allocative efficiency is a function of market structure rather than ownership. In the initial absence of competition, gains in allocative efficiency can be expected only if privatization is accompanied by liberalization policies to remove market restrictions. Moreover, the pressure of competition, which requires private enterprises to seek out opportunities to make profits in order to minimize the risk of takeover, rather than changes in ownership, may be a more significant source of productive efficiency. Given the importance of competition, the question then arises as to the relationship, if any, between privatization and liberalization.
A number of arguments suggest that liberalization cannot proceed successfully without privatization. The most important economic argument relates to the possibility of predation. A public enterprise, backed by government resources, may be able to engage in practices designed to deter new entrants, for example by reducing prices to close to or below costs. Predation can obviously coexist with liberalization in the public sector, as in the case of coach transport in the United Kingdom (see Rees (1986)). But predatory practices are more likely to occur in the private sector—indeed, it is in the context of business strategy in the private sector that predation has been a major issue—and this has been recognized in the formulation of regulatory policy in many countries. While the possibility of predation does not imply that privatization is necessary for liberalization, it does suggest that liberalization is unlikely to foster competition successfully unless accompanied by regulation to deter anticompetitive practices. In the case of public enterprises, this may require cutting off access to government financial resources to finance such practices.14
Further, while liberalization with appropriate regulation economic efficiency, if publicly owned competitive enterprises are assured of financial support from the government, they may lack incentives to seek productive efficiency. Competition among private enterprises secures full economic efficiency. When publicly owned enterprises compete in the market, economic efficiency can be maintained only if the government, while retaining ownership, requires such enterprises to remain commercially viable. If such a condition is not imposed, liberalization and regulation are unlikely to be fully effective without privatization.
While other considerations—such as political expediency—might suggest that liberalization is to a degree dependent on privatization, considerations relating to predation suggest that liberalization can proceed without privatization. But to maximize efficiency gains (subject to the qualifications outlined in the next section), privatization and liberalization (accompanied by appropriate regulation) are desirable, although, under some circumstances, it may not be in the government’s interests to pursue both. For example, one of the objectives of privatization may be to generate budgetary resources. Clearly the market value of an enterprise is determined by its current and future profitability. Governments, therefore, may be motivated to protect privatized enterprises from competition to boost their market valuation. It has been argued that this was the case with the privatization of British Telecom in the United Kingdom, where competition was also resisted by incumbent management (Kay and Silberston (1984)). The restriction of competition to boost budgetary revenue, to placate management, or to meet other short-term objectives, has potentially long-term implications; it makes any future introduction of competition difficult in that this might lower the value of shares in privatized enterprises (Kay and Thompson (1986)). Therefore, as a general rule, where privatization and liberalization come into conflict, the latter should be preferred since privatization can more readily follow liberalization than vice versa.
Competition and Efficiency
It has been argued that, where increased efficiency follows privatization, it results from a consequent increase in competition rather than from a change in ownership. This in turn suggests that the scope for enhancing efficiency through privatization is limited by the extent to which markets can be made more competitive. Among the factors that may constrain market competition, three stand out. First, public enterprises often owe their existence to market failure and, this being so, opening up a market to competition may achieve little, or may even prove counterproductive. For example, where a public enterprise is a natural monopolist, opening up a market is unlikely to attract competition, and privatization may result in a monopoly position being more fully exploited. Second, competition may not be appropriate, especially when enterprises cross-subsidize loss-making activities—a situation that often arises when enterprises have significant social and other noncommercial objectives—and the private sector can engage in “cream-skimming.” In such circumstances, the private sector will undertake only profitable activities; the public sector will be left with loss-making activities, for which budgetary support will be required unless concessions are made in respect of social objectives. The third factor that may limit competition is the difficulty of designing effective regulatory regimes. These issues are discussed in more detail below, following a discussion of contestability.
It is important to note that full competition is not essential to achieve desired efficiency: the threat of competition may be sufficient. Much has been made of an argument based upon the theory of “contestable markets” (Baumol, Panzar, and Willig (1982)), according to which a monopolist is said to operate in a contestable market when his behavior approximates that of a competitive firm. Such a situation exists only in the absence of entry restricting barriers to exit; in other words, sunk costs must be low. If such a condition holds, and if a monopolist is behaving as if he were not subject to competition, then other firms can raid the industry for part of the monopoly profit. It is therefore the fear of entry that induces the monopolist to keep prices close to costs. For the traditional public monopolies—that have large capital investments that cannot be recovered on exit—contestability is unlikely to be relevant. However, it could be more significant if the public enterprise sector contains many smaller commercial enterprises, although even when this is the case, it is difficult to think of many activities for which the assumption of costless exit is appropriate.15
The efficiency gains resulting from competition policy in a market dominated by a natural monopolist are restricted by the limited opportunities for new entrants. The core activities of these enterprises tend to resist competitive pressures, and a change in ownership through privatization will involve no more than a change in the form of regulation, with little expected impact on economic efficiency. A flexible approach to privatization may, however, stimulate competition in a natural monopoly setting, and thereby promote both productive and allocative efficiency. As described in Section III, privatization need not involve a sale of public sector assets, and other forms of privatization may create an environment of contestability. Although natural monopoly tends to be defined by the core activity—in particular, access to a network such as an electricity grid—many associated activities, such as maintenance, can be contracted out to the private sector through competitive bidding. Contracting out is perhaps the most common form of privatization, having been widely used in the local public services (such as refuse collection, catering, cleaning and laundering in hospitals).
In the case of natural monopoly, franchising offers some interesting possibilities (Kay and Silberston (1984)). A franchise involves inviting the private sector to compete for the right to operate a natural monopoly. Franchising is probably more appropriate where a natural monopoly can be decentralized, since it is better, in terms of efficiency, to have small rather than large monopolies operated by the private sector. For example, many network services can be partly operated on a regional basis. In order to maximize productive and allocative efficiency, franchises could be awarded on the basis of price and service offered rather than, as is customary, of payments made by the franchisee to the government. A need for extensive regulation will nevertheless remain to ensure that franchisees meet their obligations. In addition, unless entry costs are low, a franchisee is in a strong position either to amend the contract or disregard it.16 Franchising is also particularly susceptible to abuse. Thus, in practice, franchising is likely to have limited appeal, and activities that tend toward natural monopoly will probably continue to be undertaken by the public sector.17
If an enterprise has social or other noncommercial objectives, efficiency is necessarily sacrificed and often losses are incurred. In principle, if these objectives are sufficiently compelling it should be possible to accommodate them—especially those that involve subsidies—as part of both privatization and procompetition strategies. For example, the government could contract with the private sector to deliver essential services, keep prices below costs, and provide employment. Private sector suppliers could bid for a government subsidy, in return for which they would guarantee that the above requirements were met. However, any attempt to replace subsidies that are only implicit in existing arrangements with explicit subsidies that draw attention to the cost of meeting a particular objective are likely to face strong resistance. In addition, placing a value upon social objectives is a subjective exercise, fraught with conceptual and technical difficulties, and one that is likely to encounter strong political opposition.
Public ownership will continue to be used to further certain social objectives, although with some loss of efficiency that may call into question the cost-effectiveness of pursuing these objectives. A rigorous cost-benefit analysis of all such objectives is clearly impossible. While is some cases it will not be possible to meet urgent social priorities as effectively and efficiently by other means, there will be other cases that, even without any detailed technical analysis, will be clearly ill defined, inappropriate, and non-cost-effective. However, a large grey area-comprising objectives on whose importance there is little aggreement-will inevitably remain.
It has been pointed out that regulation is an essential component of effective competition policy. Where competition is admissible (other than in the case of natural monopolies), liberalization will result in the removal of barriers to competition, such as statutory monopoly and other forms of protection. Of course, the removal of such barriers will not necessarily lead to an increase in competition. Monopolistic enterprises in both the public and private sectors, especially if they are large relative to the size of the potential market, can erect strategic price and non-price barriers. Therefore, an appropriate regulatory regime is crucial. However, the design and enforcement of regulations in the private sector have proved difficult. It is well known that predation is difficult to establish. Often, regulators do not have sufficient information to decide whether a particular activity is anticompetitive. Moreover, once an anticompetitive practice has been identified, it may take so long to curtail that it will already have had its intended effect.18 Regulators’ decisions may also be influenced by pressure groups, by the government or the enterprise itself.
Clearly the impact of competition policy—and privatization—on the efficiency of privatized enterprises with dominant positions in potentially contestable markets will depend upon how well the regulatory regime functions. Indeed, the success of the current shift in the emphasis of industrial policy toward private competition depends largely on the effectiveness of regulation. The design of appropriate regulatory regimes will not be discussed here, although it should be noted that public ownership, despite its shortcomings, is judged by some to have proven a relatively efficient way of regulating monopolies (Papps (1975)), especially in the case of natural monopolies and elsewhere that markets are unlikely to be contestable.
This is simply the other side of the argument for and against public ownership, namely that it is necessary to improve allocative efficiency, but productive efficiency is conceded in the process. For an illustration relating to medical care in the United States, see Klein (1984).
See Vickers (1985) for further discussion of predation.
See Shepherd (1984) and Vickers and Yarrow (1985) for a critical discussion of contestability.
This has been a general problem in the case of cable television in the United States.
For a more detailed discussion on franchising, see Sharpe (1983).
The allegations made by Laker Airways that some major trans-Atlantic carriers had forced it into liquidation through predatory pricing and other anticompetitive practices led to long court battles in the United States and an eventual settlement out of court, by which time Laker Airways was unable to resume business.